What is an Annuity?
Essentially an annuity could be described as “a guaranteed income, paid to you for the rest of your life” (but possibly a fixed term – say 10 years for example if chosen). When you retire, you basically give away your pension savings (the amount you have in your pension) to an insurance company (the annuity provider) who in return pays the agreed income to you.
Basically, if you die too soon – you lose the extra money you paid out (to the insurance company), but if you are lucky enough to live to 100, you are quid’s in – simple! We call this “cross mortality subsidy” as the poor souls that die young effectively subsidise those lucky enough to survive! Simple eh?
Not so fast, like everything pensions, you will need to choose your annuity carefully so here we explain the other choices you need to make (upfront) when you agree your annuity:
Buying an Annuity
Before 2015, annuities were the “default option” for pension savings but since the reforms known as “Pension Freedoms” in 2015, their popularity has reduced sharply. The success of people living longer also means the income offered by annuity providers is at record lows, meaning many clients believe they offer poor value for money.
There are various options for your pension pot. An alternative is accessing your money via Drawdown instead, ie: drawing income flexibly as you see fit rather than a guaranteed, fixed sum for the rest of your life.
To purchase an annuity, you give away your lump sum pension savings and in return obtain an income for life. If you die too soon, you lose out (having given away your lump sum) and if you live a long time, you win (as you will receive many payments of income). We call this cross-mortality subsidy i.e those poor souls that die early subsidise those that live longer.
You should always shop around for your annuity. It is rare for your existing pension provider to give you the best rate available and therefore you should always use the open market option.
When the annuity income is paid, it is taxed as income based on circumstances, ie: the first £12,500 of total income is tax-free with income above taxed at your marginal rates.
- Guaranteed & reliable source of income for life
- Ability for your income to increase each year with inflation (indexation)
- Make provisions for your spouse
- Not Pension Drawdown (Flexible withdrawal)
- Guarantee benefits to your family (eg: 5 years)
- Considered low risk
You choose a “guaranteed period” to suit you, say 5 or 10 years for example, if you die during the chosen guaranteed period, the income will continue to be paid to your estate for the agreed fixed period of time.
Example: You die in year 2, your family receive 3 years-worth of remaining income.
THINK: If your income will definitely be paid for a period after your death, choosing a long-guaranteed period will reduce your income (on day 1)!
If you die, you can choose a specified percentage of the original lump sum you used to buy your annuity (known as the protected amount) to be paid to your estate. You may choose for example, 25%, 50% or 75% of the original income amount.
Example: You die in year 2 and chose 50% protection, your family receive (half of the lump sum given away to buy your annuity minus any income paid to you).
THINK: If you choose protection, as there is a chance money will be paid after your death, choosing any protection will result in reduced income to you on day 1!
When you die, would you like the payment to continue to a beneficiary, usually your spouse? You can usually choose a % to suit you but usually either 100% or 50% are common examples. When you die, if your spouse survives you they will then receive either 100% or 50% of your income for their lifetimes.
Example: You die in year 6 and chose a 50% spousal benefit. If your spouse survives, they will receive half of your income for the rest of their life!
THINK: Your spouse may outlive you. Therefore, choosing a dependents pension or higher spousal percentage will drastically reduce your income at outset given more will need to be paid out to spouse on your death!
Fixed or increasing/escalating?
You can choose a “fixed” income for life. Meaning it will remain level forever. In other words, if you are offered £500 per month, it will never go up to maintain your monies real spending power. An increasing or escalating annuity will go up, usually every year. You can usually choose a number of different measures including RPI, CPI or a fixed amount of say 3%.
Example: You choose fixed escalation of 2.5%. Every year your income will increase by 2.5% to try and offset the effects of inflation. You received £100 in day 1, on the anniversary this becomes £102.50 etc.
THINK: Where you choose an increasing annuity, the initial income that you are paid (on day 1) will be hugely lower than if you had chosen it to be fixed! Over time, it will increase though!
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Monthly or annual annuity?
You can choose to receive payments from your annuity either monthly (like your wages) or yearly (in a lump sum).
THINK: As there is a small chance you will die part way through the period, the income will usually be slightly higher where you choose annual payment rather than monthly!
Can you lose money on an annuity?
An annuity is a purchased product, meaning you essentially give away your pension savings to a life insurance company in return for a “guaranteed income” usually for life or a fixed period of time. Lets say for example you use your pension savings of £100,000 to buy an annuity that provides £5,000 per year income. If you die in 7 years you have only had 7 x £5,000 out (total £35,000) so yes you could lose money. However if you live for 40 years you would get 40 x £5,000 (total £200,000) and therefore you could gain greatly also. As we don’t know how long we will live it is very difficult weighing this up. We use accurate, government supplied life expectancy figures to help you understand where an annuity may fit in your retirement plans.
Is an annuity right for me?
If you want a guaranteed income for life and believe you will live a long time then yes an annuity can be great value, however not knowing our “date of death” makes it a game of chance. If however you want flexibility to draw more money out earlier in retirement and don’t mind running out of money later on then no, an annuity wouldn’t be a great idea. Weighing up all the pro’s and con’s is vital to making an informed decision. Your adviser will always explain the difference between an annuity or not, provide you with accurate quotes and help you understand whether or not one may be the right thing for you.
How much will my annuity pay me?
The simplest way to think about this is an annuity is a type of life insurance policy. They are provided by life insurers and when deciding how much they will pay you, a life insurance provider will want to know your age, smoker status, where you live and whether you have any health conditions. It sounds bizarre but the worst health you are in, the better the deal you will be offered. For example a 62 year old overweight, chain smoking diabetic with heart disease from Glasgow will get a greater annuity rate than a 62 year old from Chester who is in perfect health and goes running 3 times a week. Your expert will obtain accurate quotes based on your specific circumstances and discuss these before helping you decide what to do.
How long will it last?
Annuities can be bought for a fixed term – say 5 or 10 years, however more commonly they are bought for life. The poor souls that die sooner effectively subsidise those that live longer. If you are lucky enough to get to 110, your annuity will keep paying until death and therefore you could get back much more than you put in. Your adviser will explore all options with you helping you understand the advantages (and disadvantages) of all your options.
What are the tax implications?
An annuity is taxable income in the same way as your wages or taxable drawdown payments are. Therefore you may pay tax at 0%, 20%, 40% or 45% depending on your individual circumstances and income. Your adviser is also an expert in tax planning so we will help you understand the implications of any decision you make.
In advance or in arrears?
You can usually choose to have your income paid in advance or arrears. Where it is in arrears, you receive no income for the initial period (1st month or 1st year), whereas paid in advance means you will get the 1st payment immediately.
THINK: As the insurance company needs to pay your income “up front”, the income will usually be slightly lower where you choose in advance versus in arrears!
Other things to consider:
There are lots of insurance companies offering annuities so shopping around and using the “open market option” is vital to get the best deal! One provider may use statistics that believe you will die at 83 (on average) whereas another will have you dying at 85. Therefore provider 1 will be happy to pay you more as they believe you will not survive as long!
You can also but an “ill-health” or “impaired life” annuity, meaning if you smoke or suffer from diabetes for example, as your life expectancy is reduced, the provider will be happy to pay you more. Your postcode can also affect your annuity, those in Glasgow for example have some of the lowest life expectancy figures in the UK!
When your ready to investigate, get in touch with your dedicated experts and ensure your very own Financial Fortress!