This article has been prepared as a rough guide for those who are approaching retirement and have a pension fund with which to buy a lifetime annuity.
It explains how to purchase an annuity and what you need to think about when buying one. The aim is to set out how you can shop around to get the best deal for you. After all, you have worked hard all of your life to accumulate these pension funds, so now it is about time to put your feet up and let your money work for you.
Buying a lifetime annuity
A lifetime annuity converts your pension fund into a pension income, which you will be paid for the rest of your life. When you are approaching retirement, your pension provider will write to you with details about your pension fund. It will also tell you about using your pension fund to buy a lifetime annuity and what sort of annuity you can buy – one just for you or one to include a pension for your spouse or partner when you die, etc., but it is important to remember that you are free to shop around to find the best deal for you – you don’t have to buy it from your current pension provider.
At this point you will also have the option to decide whether or not to take a tax-free cash lump sum from your pension (subject to a maximum of 25% of the pension fund).
Under current legislation you are able to take your pension benefits from age 50 (going up to 55 from 2010). You do not have to stop working to do this but the precise timing may vary between pension schemes, so check with your pension provider.
Choosing a lifetime annuity
You can buy a lifetime annuity if you have one of the following types of pension:
- Personal pension (PP)
- Stakeholder pension
- Most Additional Voluntary Contribution Schemes (AVC)
- Free-Standing Additional Voluntary Contribution Scheme (FSAVC)
- Retirement Annuity Contract (RAC)
- Section 32 policy (buy-out bond)
- Occupational money purchase scheme
If you have contracted out of the additional State Pension (SERPS – S2P), you must use that part of your pension fund to buy a protected rights annuity. With the protected rights part of your plan you will have the same options as with your other pension funds except that you must buy a joint-life annuity paying a 50% spouse’s pension if you are married or have a civil partner.
If you have a with-profits pension fund you will be asked to state an age at which you would like to retire. Usually most people choose this to be either 60 or 65 years of age. This will then appear as your expected retirement date and some insurance companies may reduce your fund at retirement by making a MVR (market value reduction) if you don’t buy an annuity on this date.
It is very important, therefore, that you check the age you have set to retire at and whether you will be penalised if you don’t take your annuity then.
If you have more than one personal pension (or scheme listed above) then you may be able to get a higher lifetime annuity if you combine them by transferring them all into one pension plan and then buying an annuity.
Alternatively, if you do not need the income right away then you could buy a lifetime annuity with one pension fund and leave the others until later. This really depends on the type of pensions you have and is why we would recommend you to seek professional advice with an Independent Financial Adviser.
Commutation
If the total of all your pension funds does not exceed £16,500 (2008- 09) you can take it all as a cash lump sum rather than taking an income. This is known as a commutation of benefits and you must be at least 60, but under age 75, to do so and the commutation must also be done over a 12-month period. One quarter of the lump sum will be tax free and the rest will be taxed as income.
Choosing the right annuity
When choosing an annuity to suit your financial needs and circumstances the following types of annuity should be considered:
- Single life – this is an annuity just for you. Ideally this is suitable for those who are un-married or do not have a civil partner or whose partner has his or her own pension arrangements.
- Joint life – this is an annuity that will pay out to you during your life and then your spouse or partner after your death. This will not normally be at a reduced rate, with most of our clients opting for a 50% spouse’s pension when choosing their annuity. In addition to this, a client can choose whether annuity payments are to be on a level or escalating basis.
- Level annuity – this pays out the same pension income throughout your life, i.e. the income does not keep pace with inflation.
- Escalating annuity – this will normally start at a lower rate than a level annuity but will gradually build up. This can either be at a fixed rate (for example 3% or 5%) or the increases can be linked to RPI. In this case, the actual increase in your annuity will vary from year to year to keep pace with inflation. This has the benefit of ensuring that the buying power of your pension will remain the same.
There are also other options you can include in your lifetime annuity such as a guarantee period – this is used when the individual wishes to guarantee the lifetime annuity for a number of years (usually five or 10) so that it continues to pay the income for that period even if you die before then. The income will be paid to the nominated beneficiaries chosen when the annuity was set up.
Other retirement choices
If you don’t want any of the types of annuity mentioned earlier, or if you decide to delay buying a lifetime annuity, then you could consider other options (please note that some of these are only suitable if you have a large pension fund or other sources of income, and that you are comfortable taking a degree of risk with your fund).
You still have the option of taking a tax-free lump sum, after which you could choose from the following options:
- Phased Retirement – you can split your pension fund up and buy annuities at different times.
- Income Drawdown – this lets you draw an income from your pension fund while leaving it invested in assets of your choice. There are limits on the amounts you can draw down each year which are set by the Government’s Actuary Department (GAD). You are able use income drawdown until the age of 75. After this you must secure an income from your remaining pension funds, which usually involves buying an annuity from an insurance provider.
- Investment linked lifetime annuity – this relies on stock market performance and therefore your income may go down as well as up.
If, at age 75, you haven’t bought an annuity, another option is to use an alternatively secured pension. This works in a similar way to an unsecured pension but has different rules and income limits. However, the Government has indicated that they are only intended for a small group of people who have a religious objection to buying an annuity. IHT (inheritance tax) and other tax charges may apply to any left-over funds on your death.
