Pension Annuities – guaranteed income
Purchasing an annuity is just one of the options available to you in retirement. Prior to the pension freedoms changes from 2015, pension annuities were the most common form of pension income. Since then, the range of pension options such as Flexi Access Drawdown have increased substantially. Although the use of annuities is less common, they are still appropriate in certain cases.
What is a Pension Annuity?
When purchasing an annuity, you effectively exchange a cash lump sum for a guaranteed income. This income will last until you die. You have the option to take up to 25% of your pension pot as a tax-free lump sum. The balance can then be used to purchase an annuity. Most people can access their pension funds from age 55. Certain situations such as your occupation or health affect the age you can take benefits.
A simple example of this is if you have a pension fund of £500,000, you may choose to take a tax-free lump sum at age 55 of up to £125,000 and use the remaining £375,000 to purchase an annuity. The amount you would receive as an income depends on several factors. These factors include rates at the time, your age and health and the basis of the annuity. Your financial adviser should be able to research the best provider for you. Please note that payments from an annuity are taxable as income.
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The types of Annuities on offer
You may choose various pension options when you take out your annuity, which will impact the income you receive. These are summarised below:
- You may choose to purchase a joint annuity (rather than a single life annuity). This gives your spouse or partner income when you die. Generally, the level of survivor’s income will be a percentage of the income you receive, but this can still be a valuable benefit.
- Due to inflation, it is sensible to set your income to increase each year. The aim is to maintain the same purchasing power. This could either be in line with the current inflation rate, or you may set it to increase at a fixed rate.
- You may also prefer to choose an investment-linked annuity. These annuities involve an element of investment risk. Your income will vary each year depending on the performance of your chosen investments. Another example of an annuity that can decrease is a flexible annuity. With both of these types, you trigger the Money Purchase Annual Allowance (MPAA). This restricts future contributions to your pension to £4,000 per year. Contributions over this amount will be subject to an annual allowance charge. This effectively removes the tax relief you would benefit from when contributing.
Investment Linked Annuities
You may also prefer to choose an investment-linked annuity. These annuities involve an element of investment risk. Your income will vary each year depending on the performance of your chosen investments. Another example of an annuity that can decrease is a flexible annuity. With both of these types, you trigger the Money Purchase Annual Allowance (MPAA). This restricts future contributions to your pension to £4,000 per year. Contributions over this amount will be subject to an annual allowance charge. This effectively removes the tax relief you would benefit from when contributing.
Annuity Guaranteed Periods
With most providers, you will also have the opportunity to set an annuity guarantee period. This is the length of time your annuity will payout even if you die after purchasing the plan. Most guarantee periods are 5 to 10 years. If you die within this period of starting your annuity, your beneficiaries will continue to receive your income until the guarantee period ends.
Please note that your decisions when setting up your annuity are fixed and can not be changed later.
Pension Annuity death benefits
These vary greatly depending on the type of annuity you select at the outset. It also depends on the age the annuitant dies. For example, the tax treatment on death before age 75 is different to death after 75.
When the income to be paid to a survivor from a joint annuity is very small, there is the possibility that it can be converted and paid out as a lump sum. The rules surrounding this vary. However, the maximum lump sum possible under this rule is £30,000. This is known as a ‘trivial commutation lump sum death benefit’.
When is an annuity suitable?
Purchasing an annuity will not be the best choice for everyone. Retirees have the option to use a combination of pension options. Annuity purchase does not need to be the only method to provide retirement income. Below are some of the main situations when an annuity might be recommended:
- For those retirees that are not comfortable with the risk of investing – annuities are free of investment risk as the income is guaranteed for life. Some people feel too anxious when investing due to the volatility involved. In this case, an annuity may be more suitable.
- To cover essential expenses – as previously mentioned, you do not need to use your full pension pot to purchase an annuity. Many retirees choose to exchange enough of their pension to receive an income equal to basic expenses such as rent and bills. This leaves the remainder of your pension invested and spent on discretionary expenditures such as holidays or entertainment.
- When purchasing later in retirement – one of the factors affecting the rate of income you receive is how much longer you are expected to live. Therefore, the older you are when you purchase your annuity, the higher income you will receive. Some providers will not sell an annuity to those over age 75. However the rate at this age will be significantly higher than at age 55. To use the previous example, a £75,000 annuity for a healthy 75 years old would provide between £5,000 and £6,000 per year, which is more than double the rate that a 55-year-old would receive.
- In certain circumstances, providers will give enhanced annuity rates to retirees suffering from poor health. This means that your income will be higher as you are not expected to live as long as the average person your age.
Do you need more information?
In summary, annuities can give peace of mind during a time when your biggest concern may be running out of money. There is such a thing as longevity risk, which is the danger of you outliving your money, but this can be bypassed with an annuity. If you feel you need Pension Advice, please do not hesitate to get in touch. One of our retirement planning experts can assist you in making the best choices. It can be a daunting decision with the various pension options available, but we will take time to learn your situation and offer the most appropriate advice.
