An annuity is an investment sold by insurance companies. It is a way of converting a lump sum, usually a pension fund built up during your working life, into an income for the rest of your life. Unlike other investments, it cannot be used up – however long you live.
This website will help you if you are considering taking retirement income from the following schemes in the near future:
- a personal pension
- a stakeholder pension from April 2001
- a group personal pension plan arranged through your employer
- a retirement annuity contract (similar to a personal pension but sold before July 1988)
- additional voluntary contribution (AVC) schemes, if you build up your own investment fund
- a free standing additional voluntary contribution (FSAVC) scheme
It may also be useful if you are about to take retirement income from:
- an employers pension scheme that builds up your own fund – called a defined contribution or money purchase scheme
This website may not be relevant if you have a final salary pension scheme. In these schemes your income in retirement is provided by your pension scheme and you do not need to buy an annuity yourself.
How annuities work
The amount of income an annuity will pay depends on (see annuity calculator):
- the amount that you have in your pension fund;
- your age and your health at outset;
- the benefit options that you choose, such as whether it’s just for you or for a partner as well.
The amount of income an annuity provides each year in return for the lump sum from your pension fund is called the ‘annuity rate’. Annuity rates are usually quoted for a man or woman of a given age. You may see an annuity rate expressed as a percentage. For example, an annuity rate of 6% is the same as £600 a year income for every £10,000 invested. Annuity rates change frequently, so do shop around for the best deal as you near retirement.
Until 21 December 2012 (ECJ Ruling), the starting income from the same size of pension fund was higher for a man than for a woman, assuming they are the same age. This is because, on average, men do not live as long as women of the same age. However, the European Union issued a directive that prevents descrimination between men and women.
The income that you get at the start of an annuity is higher the older you are. This is because, on average, an older person has fewer years left to live than a younger person. So, an older person’s pension fund does not have to last so long.
You can usually choose for your income to be paid every month, every three months, every six months or once a year. You can also usually choose to be paid in advance or in arrears – you normally receive less if you choose payment in advance, although you would get your income sooner. There could be a tax advantage by choosing a payment in arrears (e.g. John Smith retires and his earnings for this tax year already make him a higher rate tax-payer. If he takes his annuity straight away it will be taxed at 40% in this tax year. In the next tax year John’s only income will be his annuity and this is not enough to make him a higher rate tax-payer, it will only be taxed at the basic rate. By choosing to delay his annuity income (see cost of delay calculator), John has saved the difference between higher rate and basic rate tax on the annuity income that would have been paid in the tax year that he retired.)
Why do I need an annuity?
Legislation previously dictated that an annuity must be purchased between the age of 50 and 75, this changed in 2010 when the minimum age was raised to 55 and changed again in 2011 to the extent that it is no longer compulsory to buy an annuity. However, there are certain restrictions that force you to buy an annuity, the most common being the value of the pension; <£100k and pension providers may not allow you to remain invested; if your income from other sources (secured income) does not meet certain minimum requirements then legislation may still force you to buy an annuity. More information can be found on our drawdown section should you wish to defer buying an annuity.
It is usually a good idea to take the lump sum from a pension, although there are circumstances when it might be better not to take the lump sum (e.g. if there are high guarantees on conversion to an annuity). Many people invest their tax-free cash elsewhere, either to provide a greater income or for capital growth.
Where to buy annuities
Annuities are sold by insurance companies – as with most things, shopping around can get you a better deal. Although you can usually buy an annuity from the same company with whom you built up your pension fund, do not assume it will automatically offer you the best rate. You may do better by shopping around and checking if another company could offer you more.
In most cases, you can use your pension fund to buy an annuity from another company. This is called using your `open market option’. As your insurance company may not tell you about this automatically, make sure you ask for all the information you need to shop around for the best deal.
Before shopping around make sure you understand what you already have.
- Does the company holding your pension fund offer you a guaranteed annuity rate? (In the past, some insurance companies sold these sorts of plans. Now that annuity rates are a lot lower, these guarantees can be very valuable, but might not apply to the type of annuity you need.)
- Will your existing company impose a penalty charge if you buy your annuity from another company?
- Does your fund need to be a specific size to qualify for the better rates offered by another company?
- Do you have a medical condition that could reduce your life expectancy?
Some companies are keen to attract annuity customers, so they offer competitive rates; others are less keen. The company you choose can affect your income by hundreds of pounds a year. When comparing different quotes, make sure they are based on identical benefits as there are many different options to choose from.
There can be a big difference between the best and the worst annuity rates. You will usually be worse off in retirement than you need to be if you don’t shop around for the best annuity
More than one pension fund?
If you are using more than one pension fund to buy an annuity, think about combining them when you are shopping around larger funds often attract better rates.
Advantages of combining your funds:
- many of the best-rate annuities have a minimum purchase price.
- smaller pensions may be paid less often than monthly.
- It’s often easier to budget with just one payment a month.
- the risk of having all your eggs in one basket (especially if you choose an investment-linked annuity and your provider turns out to be a relatively poor performer);
- very small pension funds can sometimes be taken as cash (i.e., you don’t need to buy an annuity), this is known as Triviality.