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What is an Annuity?
An Annuity converts your pension fund into a pension income which will be paid to you for the rest of your life.
When you are approaching retirement, your pension provider will write to you with details about your pension fund, and how you can use your pension fund to buy an annuity.
In the past annuities were purchased from the pension provider, but more recently it has become possible to shop around and approach other annuity providers to get the best deal, known as the Open Market Option.
Who can buy an annuity?
You can buy an annuity if you have one of the following pension types:
- Personal Pension
- Stakeholder Pension
- Most Additional Voluntary Contribution (AVC) schemes
- Free-Standing Additional Voluntary Contribution (FSAVC) scheme
- Retirement Annuity Contract (RAC)
- Section 32 Policy (buy-out bond)
- Occupational money purchase scheme
When do you take your annuity?
You can start to take pension benefits from age 55, and you don't have to stop working to do this. However, with people living longer, some people are choosing to delay taking a pension income and continue working instead, thereby ensuring a larger pension income later in life. When to take an annuity is a decision based on a number of factors, primarily concerning your financial well-being for the remaining part of your life.
If you have a with-profits pension fund where you have stated an expected retirement age such as 60 or 65, you will usually only be allowed to take retirement benefits at set dates in the life of the policy, such as your selected retirement date. Some insurance companies may reduce your fund at retirement by making a market value reduction or other charge if you don't buy an annuity on this date.
How your pension income is calculated
The amount of pension income you get depends on a number of factors, such as:
- The amount of money left in your fund if you choose to take a tax-free lump-sum
- The annuity rate offered by the insurance company
- The type of annuity you decide to buy
- Your age (you typically get a lower income the younger you are as the annuity will have to fund more years)
- Your health and lifestyle (you may get a higher income if you are a smoker, have high cholesterol or are in poor health. Where you live or your occupation can also make a difference)
Choosing the right annuity
There are different types of annuity to suit a range of circumstances. The main ones are:
- Single Life: This covers just you because you don't have a spouse or partner, or because your partner has made their own arrangements
- Joint Life: This will pay out to you and then to your spouse or partner after your death (normally at a reduced rate)
- Level Income: This pays out the same amount of pension income throughout your life, but does not increase in line with inflation
- Escalating Income: This pays out an increasing amount of pension income during you life, either at a fixed rate (for example 3%; or 5%) or a rate which is linked to inflation, known as RPI (Retail Prices Index). Although the escalating annuity pays out less than a level annuity initially, over time it will exceed the level annuity.
- Guaranteed Period: You can guarantee your annuity for a specific number of years (usually 5 or 10) so it continues to pay the income for that time even if you die before then. The income is then usually paid to your spouse, partner or other dependent.
- Value Protection: This is a lump sum death benefit equivalent to the pension fund you used to buy the annuity, minus the income you've already been paid and will be paid to your estate or beneficiaries. This would be paid tax free if you were to die before age 75 and taxable at your beneficiaries' marginal if you die post 75.
Enhanced and Impaired Life Annuities
Some companies specialise in offering annuities that pay a higher than normal income if you have health problems that threaten to reduce your lifespan. These are called Impaired Life Annuities, and the relevant health problems might include cancer, chronic asthma, diabetes, heart attack, high blood pressure, kidney failure, multiple sclerosis or stroke.
You may be able to get an Enhanced Annuity if you smoke regularly or are overweight. Some companies offer higher rates to people who have followed certain occupations or people who live in certain parts of the country. It is always worth checking if you may be eligible for either of these options.
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