What is an Annuity?
Most pension plans do not automatically start paying you an income when you retire. Instead, when you decide to take an income, part of your pension fund may normally be taken as a tax free cash sum with the balance being converted into an annuity, which then pays you an income for the rest of your life. Under current legislation, you have to arrange your retirement benefits with your pension fund by the age of 75.
There are two very important points to consider when setting up this income.
You do not always have to stay with your current pension provider when you retire.
Not all annuity providers are equal. The difference between the best and worst annuity incomes can be astounding.
An annuity pays you an income for the rest of your life. Annuities are provided by insurance companies. The insurance company you choose promises to pay you a regular income in exchange for your pension fund, no matter how long you live.
Once set up, the basis of your annuity is fixed and offers a secure income for the rest of your life. You can rest safe in the knowledge that your income will never run out. However, because the income is fixed it is important to choose your options carefully, as once it is set it up you cannot change your mind and it is important to note that different companies offer different annuity rates and these change frequently.
It may also be possible to obtain enhanced terms if you are a smoker or are in ill health and it is very important to always disclose any medical issues when considering an annuity purchase.
What options are available to me?
There are a number of different options you can choose when setting up your annuity. The choices you make are important and cannot be changed once the annuity is set up. You should consider both your immediate and long term needs carefully when making your decisions.
The main options that you can choose are listed below. You can mix and match these options to suit your needs and requirements.
Choose an income that pays for your lifetime only (Single Life).
If you choose this option the income is paid throughout your life only. When you die, the income will cease. The income you will receive each year from a single life annuity will be higher than a joint life annuity. However, please bear in mind that the income will cease on your death.
Choose an income that continues to your spouse or partner (Joint Life)
If you are married or have a partner one of the decisions you have to make is whether you want them to continue to receive an income should you die before them. If you do, you should think about choosing an annuity on a joint life basis. This means that after your death, your surviving spouse or partner will receive an income for the rest of their life.
A spouse's pension may be less important to you if your spouse or partner has adequate retirement income of their own. You can choose what percentage of your retirement income will continue to be paid to your spouse or partner on your death. For instance, you could opt for the pension to continue in its entirety to your spouse or partner, which is known as a 100% spouse's pension. Alternatively, you could choose the pension to reduce by half (a 50% spouse's pension), or a third (66.66% spouse's pension). The greater the spouse's pension, the lower the initial income will be. A pension may be provided to a partner if they are financially dependent on you.
If you are married or in a civil partnership, you should strongly consider choosing a joint life annuity which continues to pay an income to your spouse or partner. If you choose "no spouse's pension" please remember your annuity income will normally only be paid for your lifetime and will cease on your death. You should discuss this with your spouse or partner.
If you have protected rights and are married, separated or in a civil partnership, the annuity engine will automatically select a 50% spouse's income for your protected rights.
Choose an income that does not increase.
If you select an income that does not increase, you will generally receive a much higher initial income than an annuity that does increase. However you should bear in mind that, as time goes by, the real value of your income will be eroded by the effects of inflation.
Choose an income that increases each year or keeps track with inflation (Retail Prices Index).
If you are worried about the effect inflation may have on your retirement income, you can choose for your income to move in line with the Retail Prices Index (RPI) which means your income will keep track with inflation and therefore retain its buying power. You can also choose a fixed percentage increase each year such as 3% or 5%.
Choose an income that is guaranteed for a certain length of time.
All annuities will pay out for at least the whole of your life. However, you can also choose for your income to be guaranteed for a minimum period of time (usually 5 or 10 years), even if you were to die before then. This means if you die before the end of the guarantee period, the remaining payments left under the guarantee will be paid to your estate or the person or people you have nominated in your Will, if you have made one.
A guarantee period may be less important to you if you have chosen a joint life annuity.
Choose How Often Your Annuity Will Be Paid
You can choose for your annuity to be paid monthly, quarterly, half yearly or annually. You can also choose whether you have it paid in advance or in arrears. In advance means you receive your first payment straight away, in arrears means you wait until the end of the payment period. In arrears will be a higher income than in advance as there is one less payment up front.
What changes are happening from April 2006 ?
From 6th April 2006, pension rules are undergoing a major change. This may affect your decision whether to set up your annuity now.
The changes are far reaching. Some of the changes affecting retirement options and annuities include:
Tax free cash 25% for all
From April 2006, you'll be able to take 25% tax free cash from most pensions. This means you should be able to take tax free cash from pensions such as protected rights, FSAVCs or AVCs, which currently do not normally pay tax free cash.
However, it may also mean that tax free cash currently greater than 25% will be restricted in some circumstances.
Tax free cash from occupational schemes (including AVCs) will be taken from the scheme as a whole, which means you may be able to take more or less than 25% from an AVC. Tax free cash may also be affected by the pension scheme rules which in some cases may be more restrictive than the legislation.
More ways to take an income from your pension fund.
There will be no requirement to buy an annuity at 75, although you still can if you want to.
Instead of buying an annuity, you can opt for something called Alternatively Secured Pension (ASP) after age 75. This is where you draw an income directly from the fund, within limits. When people with ASPs die, the fund must be used to provide an income for spouse or dependants. If there is none, it can be passed onto another member of the same pension scheme or paid to charity. There are likely to be inheritance tax implications on death.
Before age 75 you'll be able to take an income directly from your fund - this is currently known as income drawdown, but will be renamed as unsecured income.
Both income drawdown and ASP contain a relatively high degree of risk - we suggest you take advice if you are considering these options.
Two new types of annuity will be introduced: a Limited Period Annuity, and a Value Protection annuity.
Take small funds as cash
If your total funds (including occupational pensions, personal pensions and pensions already in payment) are less than £15,000, you may be able to take them as a cash lump sum.
You may only do this once between the ages of 60 and 75, and 75% of the fund will normally be subject to income tax.
Changes to Retirement Age
From 2010, the minimum retirement age will be raised from 50 to 55.
From April 2006, you should be able to draw a pension from an occupational scheme while continuing to work, although the scheme rules will need to permit this.
