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Annuities
Many people are confused about pensions and exactly how they work. This is because they think of ‘pensions’ as a single entity or product and they aren’t’ The word ‘pension’ relates to the tax advantages bestowed on investment that you hold under your pension blanket. The actual investments will change over time as you make revisions to ensure good performance, but the pension blanket or wrapper remains constant.
There are two phases to pension, accumulation and income. We have spoke about the accumulation phase in previous sections but to recap; during your working life your pension is basically a savings plan with special tax treatments.
When the time comes to take your retirement benefits there are certain strings attached. You cannot for example cash in your plan and go and spend it (actually you can under certain circumstances known as the triviality rule). No, in return for the tax advantages that you were given the government puts a restriction on the amount of cash you can take from your plan at 25% of the total value. This is paid tax free and you may do whatever you like with it. It is referred to as the Pension Commencement Lump Sum. (PCLS).
The rest of your pot must be used to purchase what is known as an annuity. This is a way of converting a lump sum into a guaranteed income for life. Annuities are provided by insurance companies or specialist annuity providers and the way they work are relatively simple. You give them a lump sum of money and in return, they give you a monthly income for the rest of your life. They hope that you get hit by a bus on the way home, because they get to keep all the money whilst you hope that you live longer than Bruce Forsyth and get back more in income, than you gave them in the first place.
The amount of income money that you will receive for your lump sum will vary depending on several factors. Rates are expressed as a percentage, so a 5% annuity rate would pay out £500 per annum for every £10,000 lump sum paid.
The factors are
Age – The older you are the less time you have to live so the more generous the annuity rate.
Postcode – Statistically, different areas have different life expectancies. If you live in Reading, your annuity rate will be lower than someone who lives in Glasgow. That is because, statistically you are likely to live about 10 years longer.
Gender – Women live longer than men by about five years to their annuity rates are not as generous
Lifestyle – Smokers, drinkers and those who are overweight may qualify for a bigger annuity rate as their lifestyle factors are likely to lead to an earlier death than someone who leads a healthier lifestyle.
Health – Those with pre-existing medical conditions may qualify for an ‘impaired life’ annuity which pays a higher rate depending on the prognosis. This doesn’t need to be immediately life threatening conditions such as cancers, heart attacks or strokes but can be one, or a combination of several factors such as high cholesterol or blood pressure, or a family history of hereditary diseases.
These factors will determine the standard annuity rate offered to any individual. In addition however, annuities have several different options that you can choose that will also determine the rate.
Spouses pensions – If you have a partner or spouse then you may wish them to continue receiving an income in the event that you die first. A spouse’s annuity would pay them 50% of what you were receiving in the event of your death occurring first. They would continue to receive this until their dying day. The initial amount of pension payable to you however would be lower than a single life annuity.
Guarantee period – Remember the quote about the annuity company wanting you to get hit by a bus on the way home? A guarantee period can be selected, normally five years, and if you die within this period then the annuity will continue to pay out the income to your estate for the remainder of the guarantee period. If you also have a spouse’s option it will continue to pay out at your rate for the reminder of the guarantee period before dropping to the 50% spouses pension.
Escalating income – The annuity rate you receive may appear attractive now, but if you are planning on living for a while then inflation will reduce the buying power of your income each year. You may choose to have your annuity income linked to the Retail Prices Index or a set rate, say 3%. Each year your income will increase however the trade of is that your initial income will be a lot lower than if you chose a level annuity from inception.
The important thing is not to let these decisions worry you just yet as you don’t need to make them until you decide to access your pension benefits. If you are still accumulating your pension pot then that should be your main focus.
If you are at the stage of thinking about taking your benefits then your pension company may offer you some annuity options. Do NOT accept this offer until you have compared it with the options on the open market. It is highly unlikely that this will be the best deal available and some are downright derogatory. They may try and scare you by quoting timescales and that the world will end if you do not sign and return the forms within 20 minutes. The world will not end but you may lock yourself in to a very poor rate of income for the rest of your life because annuities are a once only deal. Once you have taken it, it cannot be changed!
If you have an old or frozen pension plan then you should have it reviewed by the qualified experts.
You may be able to:
- Increase the value of your pension
- Unlock your pension
- Consolidate your plans
- Save £thousands in pension charges
- Access better performing funds
- Release tax free cash from your plan
- Receive an immediate income
