Historically, this is the most common way to take retirement benefits, taking the maximum tax-free cash sum available and using the balance of the fund to buy a Lifetime Annuity. The income is provided on a level or increasing basis for the rest of your life and is taxed as earned income.
Annuity rates are based on your age, health, life expectancy and the level of gilt yields at the time you buy your Annuity. Payments are made at agreed intervals, such as monthly or yearly, until your death.
You can buy your Annuity from the provider of your existing pension or shop around for a potentially better rate using the ‘Open Market Option’ facility.
If you plan to buy an Annuity, it is crucial that you compare the rate offered by your current pension provider, with that which could be bought in the open market.
There are a variety of options which need to be considered, each of these will impact the Annuity rate and income you receive.
You can maximise income by limiting the number of additional options selected. However, it is important that the options you select provide you with an Annuity which is suitable for your circumstances.
An Annuity with no options included will stop when you die and never increase in value. Any options selected at outset cannot be changed once the contract has been set up. You must consider these options carefully and understand that a Lifetime Annuity income cannot be altered in the future to match changing circumstances.
The main options available include:
Typically, Annuity income is paid monthly. However, it is possible to have income paid at a different interval, such as annually, half yearly, or quarterly.
Income can also be paid at the beginning of each time period, or at the end, this is commonly known as ‘in advance’, or ‘in arrears’.
If income were to be paid annually in arrears, a slightly higher level of income would be payable than for an Annuity with income payable monthly in advance.
A Lifetime Annuity guarantees to pay an income for the rest of your life. However, including a guaranteed period means that if you die shortly after retirement, the full income continues to be paid to any beneficiary for the remainder of the guaranteed period.
For example, if you die after two years, the balance of the income due during a five year guaranteed period, i.e. three years, will be paid to your nominated beneficiary.
Typical options are to include a five or 10-year guarantee from the date of Annuity purchase. However, since the changes in 2015, longer guarantee periods, of up to 20 or 30 years, to suit a variety of needs, are becoming increasingly common.
If you select a guaranteed period you should note that it does not start from the date of death but from the date the Annuity is set up.
If you wish to protect the real value of your income, it is necessary to include annual increases when you buy your Annuity.
Indexation is normally set at a fixed percentage, or at a level to match the Retail Price Index (RPI) or Consumer Prices Index (CPI) with increases taking effect on the annual anniversary of the plan.
A level income is particularly exposed to inflation risk. This means that the buying power of your income will be impacted year on year, as the cost of goods and services rise.
Establishing an Annuity with an increasing income will have a significant impact upon the level of starting income, which is why most people chose to buy a level Annuity. There can be as much as a 30% reduction of initial income for including a 3% increasing income and up to 50% if RPI is chosen.
This means consideration should be given to the amount of time needed to catch up with the income that would have been paid from a level Annuity.
Spouse’s / partner’s pension
If you are married, in a civil partnership or have a financially dependent partner, the Annuity can be set up to continue paying an income to them after you have died. Indeed, due to a change in the rules, an Annuity can now be set up to pay the ongoing income to almost anyone you choose.
Following your death, the income can continue at the full rate, or at a reduced level, generally, two-thirds or a half.
Selecting this option may reduce your starting income, and cannot be changed. Therefore, if your partner dies before you, the Annuity terms will remain the same and the proportion of the purchase price used to buy the spouse’s pension will have been wasted.
However, this option can provide valuable peace of mind.
Overall, average life expectancy is increasing, but many people reaching retirement age are in poor health and their individual life expectancy may be less than the ‘average’ used in traditional Annuity calculations.
An Enhanced Annuity considers any health problems you may suffer from, or lifestyle issues which could reduce your life expectancy. It can therefore give you a higher income.
Typical conditions which will mean you qualify for an Enhanced Annuity, include, but are not limited to:
- The effects caused by long-term smoking
- Alcohol consumption
- High cholesterol
- High blood pressure
- Circulatory or breathing difficulties
- Heart attack
Many other illnesses, which you could be living with quite happily on a daily basis, may mean you qualify for an Enhanced Annuity.
It is essential to disclose any medical conditions to your adviser, no matter how trivial you think they are, to confirm whether you could qualify for an Enhanced Annuity.
An Enhanced Annuity works a little like life insurance in reverse. When you take out life insurance, the healthier you are, the cheaper the cost of cover.
However, with an Enhanced Annuity the less healthy you are, the more likely you are to be able to enjoy a better annuity rate and higher income.
Once you have been medically underwritten and the Annuity is purchased, the income will then continue to be paid for the remainder of your life. If this is longer than anticipated, the Annuity provider will continue to pay the income until death.
It is therefore essential that when considering buying an Annuity you provide full details of your health, including any medication that you are currently taking. Furthermore, if you are taking a joint-life Annuity, the same information should be provided about the other annuitant, usually your spouse, partner or civil partner.
Guaranteed Annuity Rates
Some older style Personal Pensions or Retirement Annuity Contracts (RACs) sometimes include Guaranteed Annuity Rates (GARs).
GARs provide potentially higher Annuity rates than are offered by today’s marketplace. If your pension includes a guaranteed rate you may have to take the Annuity in the structure dictated by the contract, which may or may not suit your circumstances.
Such terms are often very attractive and should be considered carefully. When we are advising clients, we will always check whether their existing pension has Guaranteed Annuity Rates before we recommend an alternative option.
Advantages of a Lifetime Annuity
- You have immediate access to some or all the tax-free cash available
- The income is guaranteed for life
- A choice can be made between a level or increasing income
- You have no exposure to investment risk
- A surviving spouse’s / dependant’s pension can be included to carry on being paid after your death
- Income payments can be ‘guaranteed’ for a certain period from the Annuity contract start date, so that they will continue to be paid for the remainder of the selected fixed period after your death
- The risk of you living longer than expected is transferred to the Annuity provider
- Depending on how long you live, you may get back more in income than you used to buy the Annuity in the first place
- They are relatively simple plans and do not involve ongoing planning and costs
- If you suffer from ill health, or are affected by other lifestyle factors, this can improve the level of income you receive
Disadvantages of a Lifetime Annuity
- The pension you receive depends on Annuity rates at the time of purchase, which are currently low when compared to historical rates
- Options selected at outset, which will have reduced your starting income, may never be used. For example, if you choose a spouse’s or partner’s pension, and your spouse or partner predeceases you, then the cost of this benefit has been lost
- You will not benefit from improved Annuity rates in later life, which may be generated by worsening health or by simply growing older
- Unless you include indexation, you are exposed to the risk of inflation eroding the value of your pension income
- An Annuity may represent poor value for money should you die early and do not opt for Value Protection or a Guaranteed Period
- The more features you choose, such as guaranteed periods, indexation and spouse’s benefit, the lower your starting income will be