Guide to Pension Annuities
Having successfully built up a pension fund during your working life, there will come a time when you will need to make some important decisions about how to use this fund. These decisions involve how you intend to draw your pension income to ensure the benefits best suit your needs in retirement. It is normal for people who are retiring to convert a portion of their pension fund into a tax-free lump sum with the balance used to purchase an annuity.
What is an Annuity?
With an annuity, the deal is that you swap your pension fund for an income for as long as you live. The amount of income the insurance company offers you in exchange for your pension fund is called the 'annuity rate'. Annuity rates can vary and you don't have to buy your annuity from the company that's managing your pension fund.
From 6 April 2011 an individual will not be required to purchase an annuity at age 75 although their tax-free cash will be fixed at that date. If an individual does not vest their pension plan and subsequently dies after age 75 the remaining fund will be subject to a 55% tax charge, and they will lose their entitlement to the 25% tax-free cash
There are two options open to those reaching age 75, who haven't yet purchased an annuity. The first, and most likely option, is to simply buy an Annuity. For some, there remains the option to buy an Alternatively Secured Pension (ASP). Those in Alternatively Secured Pensions (ASPs) will be forced to take income of at least 55% of the comparable annuity rate for a 75 year-old, up to a maximum of 90%. Those who fail to take the minimum income will face a charge on the difference between the actual income drawn and the minimum amount.
On the death of a pension scheme member any remaining ASP funds can only be used to pay dependents’ pensions, given to a charity or in limited circumstances paid to an employer. Any other payment will face an unauthorised payment charge of up to 70%.
Clearly, this is an important and complex area, and it is strongly suggested you take Independent Financial Advice before acting. We would be delighted to help.
What different types are there?
The income you receive from an annuity will depend on:
- the amount you have in your pension fund;
- your age at the time you buy your annuity;
- your state of health and life expectancy;
- your gender (women live longer than men and get lower annuity rates);
- the rate offered by the insurance company when you come to purchase your annuity from them; and the type of annuity you choose.
Which type of annuity you choose will depend on your circumstances, your attitude to taking some risk with investments and your expectations for the future.
Do I have to buy an annuity from my existing Pension Provider?
Even where you have been making regular payments into a pension policy with an Insurance Company, you should still consider how much pension income your fund could buy from another Insurance company in comparison to the annuity available from your existing Pension Provider. This comparison should be made regardless of how successful the existing Insurance Company has been with the investment of your money during the period before your retirement.
Good investment performance within a pension policy before retirement, does not guarantee that any annuity rates offered by the same Insurance Company will be the most competitive in the market place.
Can I purchase my annuity from a different Insurance Company?
The majority of pension plans allow the value of the fund to be used to purchase an annuity from any authorised UK Pension Annuity provider. Any existing pension fund built up within the policy can be passed across to the new annuity provider. This is known as an Open Market Option (sometimes referred to as an OMO).
If your pension policy provides an OMO it will be possible for you to purchase an annuity from the Insurance Company of your choice. This allows you to obtain the most competitive annuity available at the time of your retirement. Your Independent Financial Adviser can undertake the process of finding the most competitive annuity provider for your needs.
Can my pension annuity increase each year?
It is possible for you to choose the rate by which your pension annuity will increase each year. These increases are known as pension escalation. There is not normally any requirement to have an escalating annuity, however you should remember that without an increasing annuity the spending power of your pension will reduce over the term of your retirement. Sometimes people want a retirement income that rises in line with the changes in the Retail Prices Index (RPI).
The increases to your pension annuity are normally applied annually on the anniversary of the date that you first purchased the annuity from the Insurance Company or other provider. You must make the decision to include pension escalation at the time you purchase the annuity, as it cannot be added at a later point. The level of increase you elect to build in to your annuity will affect the starting level of the income you receive.
Under some types of pension plan there are rules regarding the maximum rates of escalation that may be provided. Also in some instances there are minimum levels that are required. This is the case if your pension has been built up from rebates of National Insurance contributions because you have elected to opt out of the Government's State Earnings Related Pension scheme or state second pension scheme. This is known as Contracting Out; normally any pensions payable from Contracted Out Pension plans must escalate.
What impact does my age or my sex have on the annuity?
A pension annuity is payable throughout the remainder of your life from the time you first purchase it from the annuity provider. Therefore your life expectancy has a great influence on the starting level of your annuity. As an example a 60-year-old person would receive a lower annuity than a 70 year old with the same sized pension fund because the younger person has a longer life expectancy.
The effects of life expectancy can also be witnessed in the difference in an annuity payable to a woman compared to man of the same age with the same sized fund. Statistically women live longer than men and this fact is evidenced in most annuities.
What are Guarantee periods?
Since a Pension Annuity ceases on your death (unless you have chosen a joint life annuity) and none of the purchase money is returned to your estate, most people look for the annuity provider to provide some form of guarantee. This guarantee provides a minimum period during which the pension will be payable. This period starts from the commencement of your annuity payments. Normally the guarantee period is five years, although under some company pension schemes this period could be as long as ten years.
Should you die during the guarantee period then your next of kin will continue to receive the annuity payments until the end of the guarantee period. Alternatively the provider may pay a lump sum in lieu of future payments, the method they use would be determined at outset of the annuity. You should ensure you are aware of the type of guarantee, if any, that you are buying when your annuity is purchased, as it cannot be changed once the payments commence.
Once I have purchased my annuity will my Pension fund continue to grow?
By purchasing an annuity you lock in to a long-term income stream. Any Pension Fund used to buy such an annuity no longer belongs to you. Therefore not only would it not be returned after your death but should the investment markets rise sharply your income level would not be changed. Of course the same is true if the investment markets fell after you had purchased an annuity, namely a fall in market values has no effect on your income.