2. Annuity Purchase

How does it work?

Buying an annuity means using your pension fund to buy a guaranteed income (an “annuity”) for a specified period of time (usually for life following retirement). A proportion of your fund can normally be taken as a tax-free lump sum with the balance purchasing an annuity. The maximum amount of tax-free cash is 25% of the fund value unless protection is in place from a previous scheme

The amount of pension income you can expect to receive depends on several factors prevailing at the time of annuity purchase:

Age: generally, the older you are (and your spouse if a widow or widower’s pension is required) the higher the level of income you may expect to receive.
Health: if either you or your spouse does not enjoy good health there are providers that can offer enhanced levels of annuity.
Annuity rate: The level of annuity (the “rate”) offered at purchase date is influenced by current and future expectations for interest rates, as determined by the provider. The rate determines the total amount of pension that can be purchased. The higher the rate, the larger the pension that can be secured from your pension fund. In recent years annuity rates have fallen and this has resulted in a general reduction of the level of annuity secured for a given sum. Increased life expectancy also affects annuity rates as product providers now expect to pay annuities for longer.
Value of your pension fund: The greater your fund the more guaranteed income you will be able to secure. Naturally, where you elect to take part of the fund as a tax-free lump sum this will reduce the level of income attainable.
Extra features: Benefits may be added where they are of particular interest to you. However, their inclusion will reduce the level of annuity. For example, a pension with a level income will provide a higher income initially than one set up to increase every year. Any features must be selected at outset, as it is not permitted to add these on at a later stage. The most common benefits available are:
Spouse’s pension so that income continues to be paid to your spouse in the event of your death.
Annual percentage increase to the level of pension income, providing a degree of “inflation proofing”.
Guarantee to pay the annuity for a minimum period (e.g. 5 or 10 years).
Annuity Protection
Choice of Provider: When considering annuity purchase, it is important to remember that you do not always need to purchase the annuity from the company used to build up the fund. This company may not offer the best annuity rates, as the level of pension will vary from one provider to another. In recognition of this the majority of providers allow transfer to an alternative annuity provider at little or no cost. This is known as the “open market option”. It therefore makes sense to shop around for the best possible pension.
Timing of purchase: The annuity rates prevailing at the date of purchase determine the amount of annuity you will receive and the use of the open market option may secure a better annuity.

What happens when you die?

If you selected only a single life annuity at outset the payments will cease upon your death. However, where you have selected other benefits, for example a spouse’s pension, further payments may be continued, according to the terms and conditions agreed. Annuity Protection will purchase the facility to take the remaining fund (initial purchase price less income taken) as a lump sum less a 35% tax charge. This facility is only available up to age 75. These options are fixed from the outset, and cannot normally be altered to adapt to changes in your personal circumstances.

Taxation issues

The income from an annuity is subject to income tax.
When tax-free cash is taken at outset and not utilised, it may be included in the value of your estate and therefore increase any potential inheritance tax charge.

Alternative types of annuity

There are different types of annuity available, which are described in more detail below:

a) Conventional Annuities

This is the “traditional” method of converting a pension fund into an income for life. A basic conventional annuity is one that pays out an income for the life of the annuitant (the person purchasing the annuity) and ceases on death, unless any optional features have been incorporated, as described above.

By buying a conventional annuity you will be guaranteed an income for life, irrespective of any subsequent movement in the investment markets.

When looking at conventional annuities there are two further areas that must be considered:

i) Enhanced annuity rates. It is sometimes possible to obtain higher annuity rates than are generally available where the annuitant’s medical history, former occupation or lifestyle are deemed by some insurers to reduce life expectancy. It is therefore important that any reason that may qualify you for an enhanced rate is established.
ii) Guaranteed annuity rates. In the past some pension contracts provided for a guaranteed level of pension income at retirement. Recent economic conditions have meant that in many cases the level of guaranteed income is higher than could be obtained by purchase of an annuity in the open market and hence these can represent particularly good value. These guarantees tended to apply to policies set up before 1988, known as “Retirement Annuity Contracts”. Your Adviser will assist you in determining whether this applies to your pension(s).

Advantages (conventional annuities)

You are able to take the full tax-free cash sum entitlement at outset.
Income is paid at least for life, and longer if relevant features were selected at outset.
The benefits selected are guaranteed and income is not affected by future falls in interest and or annuity rates.

Disadvantages (conventional annuities)

You lose ownership of the fund in exchange for the purchase of the annuity. Because of this, in the event of early death, you may not get value for money – although this may be offset by the provision of a spouse’s pension, or annuity protection.
Annuities are inflexible to the extent that once purchased, they can’t be altered to reflect changes in personal circumstances.
Where a level annuity has been selected, inflation may erode its value.

For whom might conventional annuities be suitable?

Such contracts may be suitable for those who have a need or desire for a predictable, guaranteed annual income level.

b) Investment Linked Annuities

Investment linked annuities work on similar principles to those of conventional annuities. The difference is that the level of income is determined, at least in part, by the performance of the underlying funds, rather than by guarantee at outset. Consequently the level of income will depend upon investment returns.

A with profits annuity provides you with a regular income for life. Income is derived from two elements:

(a) a guaranteed minimum income;
(b) any annual bonuses paid which, once added cannot be taken away.

Usually you will be asked at outset to select an “anticipated” or “assumed” future bonus rate, for example between 0%-5%. This will in turn determine the actual level of income initially paid. Bonuses actually paid reflect the investment performance of the assets within the with profits fund and, as such, cannot be guaranteed.

Thus, if bonuses actually paid fall short of the “assumed” rate, your income could fall. An element of security is added however, due to the way with profits funds “smooth” returns to reflect the ups and downs of investment markets.

Advantages (investment linked annuities)

You are able to take the full tax-free cash sum entitlement at outset.
Income is paid at least for life, and longer if relevant features were selected at outset.
They offer the potential to improve retirement income through future investment growth.
The guarantees implicit in most with profit annuities afford a degree of security as to minimum income level.
Investment linked annuities can offer flexibility to alter income in line with circumstances, for example by changing the assumed future growth rate, converting to a conventional annuity or, in the case of a unit linked annuity, switching between a range of investment funds. Note: It is important to check the individual product provider’s contract, as not all will offer these features.

Disadvantages (investment linked annuities)

You lose ownership of the fund in exchange for the purchase of the annuity. Because of this, in the event of early death, you may not get value for money – although this may be offset by the provision of a spouse’s pension and annuity protection.
Other than any contractual guaranteed minimum income, there is no guarantee as to future income levels generated.
The “assumed” future bonus rate will affect the level of income payable, both at outset and in the future and, if the assumed bonus rate is set too high, future income may fall.
The cost of guarantees implicit to with profit annuities may limit potential returns.
Charges for investment linked annuities are generally higher than a conventional annuity as they are more complex to administer.

For whom might investment linked annuities be suitable

For those whose other retirement income is already secure, perhaps from a final salary pension scheme, or who have other assets.

For those who can afford to take a degree of risk with their retirement income and are attracted by the possibility of improving future income via continued exposure to stock markets.

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