Annuities have been the backbone of many retirement incomes for years: unfortunately, this doesn’t mean they have been universally loved. As the returns from annuities have shrunk over the years, so has enthusiasm for the products. It means there were celebrations all round in 2015 when the government decided to banish the compulsory purchase of annuities, and give us the freedom to do what we like with our pension pot. The question is whether annuities still have a role to play in securing your pension income.
- What is an annuity?
- What are the changes to the annuity rules?
- The most important thing you need to know about retirement annuities
- How to find the best retirement annuity
The idea is that if you have a defined contribution pension, you retire with a pot of money. In the past, at some point, you would have to spend that money on an annuity. This would swap a lump sum for a regular monthly payment for life. It doesn’t matter how many years you last – one year or forty years, you will still get the same amount of money every month until you die.
The big advantage of annuities is that they introduce certainty into your pension planning. You know what you will get each month, and you can be confident your money will last for as long as you do. The drawback is that rates have been dropping for decades, so the returns have often been disappointing.
Also, for those that last a long time – well done you – inflation can eat into your income because it is a fixed income while prices go up around you. There are inflation-linked annuities which go up in line with inflation (in theory) but they start from a lower level than the fixed ones and the increases often lag behind the rises in inflation.
‘Pension freedom’ rules introduced in 2015 did away with the need to buy an annuity at all and opened up a number of different options.
The idea of pension freedoms was to stop people feeling railroaded into buying annuities. Instead, they can dip into their pension pot whenever they like – and take as much money out as they like. The only caveat is that they will pay tax on withdrawals at their marginal rate (20% for a basic-rate taxpayer, and 40% or 45% for those with higher incomes).
This essentially introduced six options. You can:
- leave your pension untouched and continue to work or draw an income from elsewhere
- buy an annuity
- draw an adjustable income from the pension pot (Flexi Access Drawdown)
- take chunks of cash as and when you need it (Uncrystallised Funds Pension Lump Sum)
- cash it all in whenever you like
- do a combination of these things.
Details of each of these options are available from the Pensions Advisory Service.
The right approach will be different for everyone, and there are pros and cons associated with each. So, for example, if you go into Flexi Access Drawdown, you can take the income you need, but there will be charges, and you may run out of money before the end of your retirement. Meanwhile, if you opt for an annuity you have a guaranteed income for life, but you may be disappointed with the rate of return.
In some cases, it may also make sense to switch from one approach to anther. So, for example, you may want to leave your pension pot untouched for a few years. You might then want to draw some lump sums, and then a few years after that, buy an annuity. The new rules give you the freedom to be able to do this – although you cannot sell an annuity back once you have bought it.
The myriad of choices means that in most cases it is worth getting help. It may make sense to pay for independent financial advice. If the cost concerns you, you may prefer to take guidance from the government’s free Pensions Wise service.
If you decide that annuities should make up at least part of your retirement income, the most important thing to remember is that you need to shop around for the very best one.
We don’t wish to panic you, but this is one of those once-in-a-lifetime chances to get it right. Once you have chosen your annuity, that’s it for the rest of your life. That’s what you’ll get. So it’s really important. Take your time over it. Consider all the types of annuities available and which one suits you. Don’t be bamboozled into taking whatever your pension company wants you to take: look around the whole of the market to find the best retirement annuity for your circumstances. The Money Advice Service has useful information on how to shop around.
Your pension provider will try to get you to accept the annuity they offer – and it’s possible that it is the best, though that’s unlikely. You can often negotiate a better deal from them if you don’t accept their first offer.
The best thing, though, is to look around all the annuity providers and see what they offer. Also, consider the type of annuity you want:
- ‘fixed rate’ (the downside of these is that if inflation goes up a lot, you will still have the same amount of money coming in – so it will buy less for you)
- ‘index-linked’ – in other words it tracks inflation (the downside here is that these tend to start off very low and take a long time to creep up, and they tend to lag behind inflation too)
- an annuity that will pass on some of the money left in your pot when you die to your family
- an annuity that will pay your partner an income if you die
- investment annuity (this could go up over the years or it could do badly, depending on what it is invested in).
- ‘flexible annuity’ – which allows you to vary your retirement income year by year to a certain extent.
If you are not in excellent health, there’s also a good chance you can get what is known as an ‘impaired life’ or ‘enhanced’ annuity. This will pay out a larger sum each month on the grounds that the insurance company selling the annuity thinks you will have a lower-than-average life expectancy.
Its well worth anyone looking into these because they pay out for conditions such as diabetes and high blood pressure – as well as things like cancer and heart disease. In some instances they pay 50% more than a traditional annuity, which could help make this a far more attractive option.