As you reach retirement you need to start thinking about what you will live on when you no longer receive an income from work. Anyone who has built up a pension can take up to 25% as a tax-free lump sum. If you have a private pension fund or a work pension which is not a final salary scheme, you will need to use the rest of your pot to provide yourself with an income. The usual way to do this is by buying an annuity.
What is an annuity?
An annuity is a contract with a company to provide you with an income for the rest of your life, which you buy with your saved pot of pension money.
How much you get depends on a staggering number of factors: the size of your pension pot, your age, occupation, any illnesses, whether you've smoked (or still smoke), whether you are taking out a single or joint policy, as well as interest rates, inflation and the demand for gilts, or government bonds (see below).
Whatever income you get will be subject to tax if, together with any other income, it adds up to more than your annual personal allowance.
Buying an annuity can be a gamble: if you live a long, healthy life you can be quids in; if you die a year later, all that saved money can disappear into the pension company's pocket.
Different types of annuity
The income you get will depend on the type of annuity you buy. The major types of annuity are:
Level annuity. A set income offered by an insurance company which is paid out at an agreed frequency. This can be monthly, quarterly, half-yearly or yearly. It will not go up or down, so inflation will erode your spending power every year. At first it will generally offer a better rate than an increasing annuity.
Percentage increasing annuity. Your annuity will rise by a fixed percentage, usually 3% or 5% a year. This will help your income keep up with inflation. However, you will have to pay for this guaranteed uplift – you will get around 30% to 50% less a month at the outset, depending on the rate of increase chosen.
RPI-linked annuity. Your monthly payout will rise in line with inflation and protect you from losing your purchasing power. However, this comes at a hefty cost – usually between 40% and 50%. There is also a chance you could end up with less if retail prices begin to fall.
Enhanced/impaired annuity. If the company providing your annuity thinks it will only have to pay you for a few years, it may offer you a higher income. These annuities are available if you've suffered or are suffering from one of a range of illnesses that may shorten your life expectancy eg high blood pressure, diabetes, cancer, a heart attack, Parkinson's disease or MS. The insurer will usually raise your income, sometimes by as much as 30%.
Joint life annuity. Passing on part of your defined-contribution pension (normally 50%, 66.66% or even 100%) to a partner when you die may be attractive, but the cost is a lower initial income.
The importance of shopping around
What you get for your money will depend hugely on the insurance company you buy your annuity from.
According to JLT insurance brokers, which operate the Annuity Bureau, in February 2013 a £100,000 pension pot from a 65-year-old non-smoking retiree would buy a level annuity paying £496 a month from Aviva but only £414 from Standard Life. Pick a 3% increasing annuity, instead, and the sums drop to £352 and £276 respectively. However, go for an RPI-linked annuity and your best deal is still Aviva at £306 a month; the worst is Prudential, at just £234 a month.
Shopping around for the best rate on your annuity can easily increase your income by a fifth. The government's Money Advice Service can help you find a provider.
A riskier option
Conventional annuities offer the safety of a fixed income, but control over your fund is handed to the insurance company, which invests the money in accordance with certain rules. If you're prepared to take some investment risk in return for potential growth, you could consider an investment-linked annuity.
In a nutshell, what you get each month is based on the stock market and other investments: if returns are robust, your income will rise. However, as recent yo-yoing stock markets reveal, your income can fall. You can pay for a "floor" to be installed, though, to prevent big losses, but this can reduce your level of income.
You can always spread your risk by buying more than one annuity: for example, you could spend £150,000 on an ordinary level annuity and £75,000 on an investment-linked annuity.
Go for a guarantee
Another option on the table is a guaranteed annuity, offering payments for a fixed period of, normally, five or 10 years, regardless of whether you live or die. If you die within the set period, your partner or whoever you've nominated on the policy will be paid out the balance of the guarantee. If you don't, you continue with a level annuity. The rate will be less because you have paid for the guarantee.
The postcode effect
Increasingly, insurers are applying "postcode pricing" to applications for policies. If you've lived in a less affluent area where statistically you're more likely to have had a manual job, this could boost your income by around 5%.
Legal & General, Aviva and Prudential all offer enhancements if you live in an area such as Glasgow, where life expectancy is lower than normal. On the other hand, residents of Kensington & Chelsea could find themselves with much less, as their life expectancy is greater.
Alternatives
You are no longer obliged to buy an annuity with your pension fund. If you have a large pension pot – at least £250,000 – you can opt for an unsecured pension (USP), which used to be known as income drawdown. This pays you a regular income without you losing ownership of your fund.
This way, you keep control of your pension fund rather than ceding it to an insurance company. You can take the tax-free cash from it and within certain limits vary the amount of income that you take. You can pass on the fund as a lump sum to your beneficiaries when you die, but there's a 55% tax charge if you do.
Variable and fixed-term annuities, also known as "third way" pensions, set out to offer the best of conventional annuities (a guaranteed income) with some of the flexibility of income drawdown (the potential for investment growth). These are only available from a small number of providers.
Take advice
To ensure you make the most of your pension fund and get the best income you can, it would be wise to take specialist financial advice. Make sure your adviser is properly qualified to deal with pension arrangements.
• For more, try information: annuity-bureau.co.uk, annuitydirect.co.uk, Hargreaves Lansdown.
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