What is an annuity?
Annuities, sometimes referred to as guaranteed income products, provide a regular income for life or for a fixed term, so they are a good option if you want peace of mind or are worried about your money running out during your retirement. Annuity providers buy gilts to underpin annuity payments. This means that the income paid by an annuity is linked to the yield generated from the gilt. As such, lower yields result in lower annuity rates.
Normally, you can buy an annuity from your existing pension provider if they offer this facility, or if not, you can go to another. It is important to shop around and compare annuity rates using what is called an ‘open market option’. This simply means that the person purchasing the annuity is free to buy one from another provider in the market.
As a rule of thumb, the older you are when you take out an annuity, the higher the income you will receive.
What are the different types of annuity?
There are a number of different types of annuities, each with their own features and benefits:
Conventional annuities. These pay a fixed income that is agreed from the outset for life. The main benefit of this type of annuity is the security that it offers, because the income is guaranteed until you die.
Enhanced annuities. Your health and lifestyle choices will influence the amount of income you receive. If you smoke, are on certain types of medication or have a life-limiting medical condition, you may be eligible for an enhanced annuity, which tends to pay a higher income because it is expected that it will be paid out for a shorter period of time.
Variable annuities. The income paid is based on the performance of selected investment funds and can rise or fall in value.
Fixed annuities. Usually, the income is paid for a set term, for example, 10 years. You are not tied to this for life.
Immediate needs annuity (also called an immediate care annuity or a care fee plan). These work in a similar way to an ordinary annuity, except the income goes directly towards the costs of long term care. The main advantage of paying for care fees in this manner is that the money from the annuity does not count as income so is not subject to Income Tax. In this way, it can deliver a higher amount to pay for care than you might be able to achieve with an ordinary annuity.
Compulsory annuities. In the past, most people had to buy an annuity with their pension when they reached retirement. This is not the case anymore following the introduction of pension freedoms in 2015.
Purchase life annuities. The income paid under these contains a capital and an income element. The capital element is treated as a return on your original investment and is tax-free. The income element is taxed.
Deferred annuities. These plans only start paying out in later life. You would need to have an income from other sources, such as savings and investments, to fund your lifestyle until the payments from this plan are received. Deferred annuities have become less popular as many people do not like the idea of buying something upfront that only starts paying out about two decades later.
What are the lifetime income options with an annuity?
In addition to being able to choose when your income is paid (monthly, quarterly, half-yearly or annually), you have choices when it comes to securing your income for both you and your loved ones when you purchase an annuity.
Level or escalating income. You can choose an income which is fixed at the same amount throughout your life (level), or one that rises over time by a set amount or by inflation (escalating). While escalating income will protect you against inflation, the amount of income payable starts at a much lower rate. Level income does not protect you from inflation, but it does provide the security of a known, fixed income.
Single or joint life. You can choose to make a provision for your financial dependant. In the event of your death, your pension annuity income will continue to be paid to this person. As the name suggests, a financial dependant is someone who relies on you financially. Normally, this is a husband, wife, civil partner, cohabitating partner (you do not have to be married to or in a civil partnership) or a child. An annuity provider will usually request some sort of evidence that this person is financially reliant on you (a bank statement is normally sufficient).
Guarantee period. You can set a guarantee period of your choice and if you die during this time, the annuity provider would continue to pay an income to your estate or beneficiary until the guarantee period expires. This helps to protect your initial investment in the event of your death. The guarantee period can range from one year to the maximum amount set out by the provider. For example, you could select a timeframe of 10 years. If you were to die after two years, the income would be paid out to your nominated beneficiaries for the remaining eight years of the guarantee period. It will be free of Income Tax if you die before your 75th birthday, but if you die after this, it is taxed at the recipient’s marginal rate.
Value protection. This protects any capital that has not been utilised from the original annuity purchase amount when you die and it is then passed on to your beneficiaries. For instance, you purchased an annuity for £100,000. You have taken £90,000 as an income from it. When you die, the remaining £10,000 will be returned to your estate as a lump sum. This payment is liable to Inheritance Tax.
Why have annuities become less popular?
For pensioners with defined contribution schemes, annuities were once the go-to option. However, Government pension policy and wider economic factors have meant the tide has shifted away from annuities towards other, more flexible pension options. The introduction of pension freedoms in 2015 substantially increased the choices available in the defined contribution market, as savers were more attracted to the new drawdown and lump sum options.
Challenges within the annuity market itself have also been part of the reason they have fallen in demand. These include reducing gilt yields, increased mortality rates, reduction in morbidity rates and reduced competition between providers. Annuities have also received a lot of negative attention because very few people shop around with alternative providers or for enhanced annuities.
Do annuities still have a place in retirement planning?
It’s always worth remembering that when you are looking at your pension options at retirement, it isn’t an all or nothing decision and a hybrid approach could be a more effective way to take an income. You can use part of your retirement pot to buy an annuity and take the other part as drawdown.
Buying annuities in tranches can reduce your exposure to investment risk as you age. It’s also worth remembering that annuity rates increase as you get older and could be much higher than you think if you have certain conditions or illnesses that could have an impact on your life expectancy.
Later in your retirement, when you’re more likely to have one or more health conditions that entitle you to an enhanced annuity, you can buy another annuity with another tranche. This gives you the best of both worlds, as you have the security of an income without buying into rates at any one time.
Please do bear in mind that once you have bought an annuity, you have very little time to change your mind so you must think carefully before you commit to this option for your pension.
Talk to Evelyn Partners
If you want to know more about your pension options at retirement, contact Evelyn Partners to book a free of charge, initial consultation online or call us on 020 7189 2400.
This article was previously published on Tilney prior to the launch of Evelyn Partners.