Pension Annuity

pension annuity

This page was last updated on 1 December 2020

Pension Annuity – A complete guide

What’s an annuity?

An annuity is an asset that you can purchase to provide you with guaranteed income for the rest of your life. The guaranteed income of an annuity ensures you can maintain a certain lifestyle, and alleviates the burden of managing your pension pot.

Topics that you will find covered on this page

You can listen to an audio recording of this page below.

What is a pension annuity?

Annuities can be divided into two main categories: Purchased Life Annuities and Pension Annuities. Purchased Life Annuities are, except for tax technicalities, effectively the same thing.

The sole difference is that a portion of your income from a Purchased Life Annuity is legally considered capital repayment, and is thus tax-free cash. 

If you buy a pension annuity, the entirety of your annuity income is eligible for Income Tax. In this article we will be exclusively considering pension annuities.

Here is a video that explains how an annuity works.

How much retirement income would an annuity provide me with?

A few considerations affect the level of guaranteed income you could receive from an annuity. The following factors come into the annuity calculation.

Age

How old you are when you buy an annuity affects how much you could get. If you buy an annuity early in your retirement, you could get more pension income overall. But the initial annuity rate will likely be lower.

Health

Your health condition also affects what kind of annuity rate you can expect. If you smoke or have a long-term illness such as high blood pressure or diabetes, this can increase the starting income.

This is because companies don’t expect those in poor health to live as long. So if you are in poor health, the pension provider may end up giving you less in income payments overall in the event of early death.

Interest rates

Interest rates have an effect, as does the rate of inflation reflected in the retail price index. Gilts (or government debt) also affect the income attached to annuities. This is because providers invest in gilts to fund payouts.

Can I sell my annuity, or cash it in for a lump sum?

Unless you have purchased it very recently, you cannot cash in your annuity.

Many pension annuity providers allow the cancellation of a purchase within a fixed term of a month or so. In this case, you are not strictly cashing in the pension annuity, but cancelling your purchase altogether. If you recently made a purchase and wish to cancel it, contact your pension annuity provider to discuss your options.

If you already have a pension annuity, you cannot cash it in for a lump sum. Nor can you sell it. This is because annuities are designed to provide you with income for the rest of your life. Pension funds use your pension pot to invest in long-term assets for a stable return. They cannot simply dissolve these investments to pay you a lump sum.

annuity calculator

What are the main advantages of pension annuities?

  • Guaranteed income for life is an obvious upside. Compared with other forms of pension, an annuity is the most reliable way to ensure you can maintain a certain lifestyle throughout your retirement.
  • The level of income can be varied based on your need. Plus, many companies provide annuity calculators on their website so you can find out what suitable packages they offer. So finding out the best option for you can be quick and easy.
  • You can purchase both you and a loved one income for life through a joint life annuity.
  • Annuities can track the RPI if you want to maintain your income’s purchasing power.

What are some of the disadvantages?

  • Over a certain threshold, your income is fully taxable. If you were to make investments through a tax shelter such as an investment ISA, any dividends and interest income would be non-taxable. So you might want to consider alternative pension arrangements if you are already in a high tax band.
  • Although you can include a loved one in your plan, they cannot receive a lump sum upon your passing. If you wish to help out your beneficiaries with getting on the property ladder for example, an ongoing income might not be as much use.
  • After a fixed term has expired annuities cannot be sold, nor can they be cashed in. So if your plans are likely to change- for example, if your health deteriorates and you develop different income needs- pension annuities might not be right for you.
  • The income you can get from annuities tends to reflect gilt yields, and these are presently at historic lows.

"Annuities can be divided into two main categories: Purchased Life Annuities and Pension Annuities. Purchased Life Annuities are, except for tax technicalities, effectively the same thing."

How much cash do I need to buy a pension annuity?

In practice, you can often buy one with very small amounts – think twenty thousand pounds or less. But there is little point in buying an annuity with such a small lump sum, as you won’t be able to live off the income it will provide. Plus the service charges make such small purchases highly inefficient.

As a rule of thumb, a pension pot of at least 100,000 pounds is enough to buy an annuity that will make a difference to your lifestyle. A five per cent annual yield on a 100k pension pot will provide you with 5,000 pounds in guaranteed income. (This is also tax-free, being within your personal allowance.)

That’s not a fortune, but it can form a part of your retirement income, on top of the state pension and any other arrangements you may have made.

annuity

What is the tax status of a pension annuity?

Pension annuities are taxed the same as ordinary earnings. So the rate of Income Tax you pay on your pension annuity income depends on what tax bracket you’re in. 

The tax-free allowance was higher for retirees until recently. Though this is no longer the case, the first £12,500 of your annuity income is still tax-free cash.

What happens to my annuity when I pass away, and can I bequeath it to someone in my will?

The level of death benefits your family will receive depends on the conditions of your annuity. But in most cases, your beneficiaries will have no benefit entitlements. Pension annuity payments end when you pass away, unless it had a spouse element attached to it.

If you purchased the annuity briefly before you passed away, this can be different. A beneficiary may be entitled to a lump-sum payout if you die within the first three months. A guarantee period also extends beyond this point, and up to 5 years normally. If you die within this time window, your beneficiary will receive annuity income until the guarantee expires.

Many name their spouse as a dependent on their pension annuity. In this case, your dependant will continue to receive a regular payment. This can be a good option if you are worried about your passing having a detrimental impact on your loved ones’ finances. A similar option worth looking into is a joint life annuity.

What are the different types of pension annuity? Is there a difference between a lifetime annuity and a scheme pension?

Scheme pensions and lifetime annuities are the two main types of pension annuity. The primary distinction between them lies in whether the recipient can decide their insurance company.

With a lifetime annuity, the member can shop around and choose between options themselves. But with a scheme pension, the annuitant is paid directly from their pension scheme, or their pension specialist chooses an annuity for them. This is often an employer pension scheme.

Are pension annuities safe?

Pension annuities are some of the safest retirement options out there. This is because with a pension annuity, you have guaranteed income for life. Compared to a Self-Invested Personal Pension, for example, annuities are extremely safe, as your income is not tied to a fluctuating market.

Annuity providers are strictly regulated by the government, meaning annuitants have a high degree of protection.

It’s important to avoid scams when seeking annuity quotes. As long as you stick to legitimate annuity providers, there are no risks as long as you research your options before making any decisions. If you feel unsure, it can be a good idea to seek independent advice and guidance in advance of your decision.

What if the company managing my annuity fails?

In the event of business failure, you will not be left penniless. The UK Financial Services Compensation Scheme will cover your pension pot up to a value of £85,000, and it costs nothing to make a claim.

How long should I spend making a decision?

It is a good idea to consider your options before you buy, as it’s a decision that will affect you for the rest of your life. If you make a snap decision, you could get saddled with an annuity that doesn’t meet your needs.

So, since you can’t sell your annuity or cash it in after a certain period, it’s certainly worth taking the time to review your options. Some even take a few weeks or months to mull things over. This is wise as long as there’s no urgent need for a decision. You might also end up with a higher income if you spend more time looking for deals.

What providers can I purchase an annuity from?

Depending on your current pension arrangements, you may be locked into a plan with your provider. If this is the case, you might end up with a scheme pension, in which your provider pays you directly, or selects an insurance company on your behalf.

Those considering purchasing a lifetime annuity have a variety of options to choose from. The household name insurance companies all provide a wide range of annuity types and income options. These vary from standard packages covering the basics to more complex offerings. Their websites will often feature an annuity calculator, which is a handy way of comparing options.

There are also a number of small start-up companies offering pension pot options. As long as they are fully regulated by the FCA, you have nothing to fear from these newer firms, and they might offer you a better quote than the old guard. But it is crucial that you question the legitimacy of any unknown provider that asks for your information.

As always, if you feel unsure about your decision, you can consult an Independent Financial Adviser for pensions guidance. Their fees can seem a bit steep, but consider it an investment. Financial advisers know how to shop around, and their experience can help you get a better deal than you otherwise would. 

annuity rates

Should I go for the highest annuity rates I can get?

It seems intuitively obvious that when you buy an annuity, you should choose a higher income if you can. But it’s worth remembering that an annuity is for the rest of your life. It is a bad idea to look at the initial amount in isolation from your later income.

An annuity with a lower initial yield might end up paying more later on. Some annuity yields change with the retail prices index. Inflation will be matched by an escalation in your income.

These features offer insulation against changing circumstances. If you fear inflation eroding the value of your pension pot, these might be a better option than a set percentage.

If you want added support for a loved one in the event of your death, you might have to trade this off against a higher income. Since insurance companies will end up paying out more money to those who purchase these annuities, the income attached is generally lower.

At what point should I make my purchase, and is there an age limit?

There used to be a limit on when you could buy an annuity. But since 2011, you have the opportunity to buy annuities at any age. So in itself, time doesn’t influence your annuity options.

When calculating an annuity, those of a more advanced age often receive a higher income. This is because, as you near your life expectancy, ‘income for life’ realistically amounts to less. But as the last section discussed, income isn’t everything.

Older retirees might be thinking about what happens when they have passed, and what arrangements they need to make for their beneficiaries. With this in mind, an annuity might not be the best option because death benefits cost more in deductions from your income.

Likewise, if you are only just retiring, you should not be put off by seemingly lower rates. Your income might increase down the line. Plus an annuity can provide certainty for the whole of your retirement.

Article author

James Lloyd

I am the primary writer and author for Help and Advice, having originally helped start the site because I recognised that there was a need for easy to read, free and comprehensive information on the web. I have been able to use my background in finance to produce a number of articles for the site, as well as develop the financial fitness score tool. This is a tool that provides you with practical advice on improving your personal financial health.

Outside of work I am a keen rugby player and used to play up to a semi-professional level before the years of injury finally took their toll.  Now you are more likely to see me in the clubhouse enjoying the game.

Email – james@helpandadvice.co.uk

Linked in – Connect with me

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