Annuities, Pension Annuity and Open Market Options

We have been advising our clients in Norfolk and Suffolk about their retirement options and find that the choices are becoming even harder to make, despite "Pension Simplification" in April 2006. Asset Investment Management also offer a dedicated Pension Annuity Help website.

Why do I need to buy an annuity?

Current legislation stipulates that you must purchase an annuity with your personal pension or stakeholder pension funds between the ages of 50 and 75. Usually you can take up to 25% of your pension fund as a tax-free lump sum, although the exact amount will depend on the type of pension that you have. Interestingly this has recently been renamed “Pension Commencement Lump Sum”, so whether or not the exchequer has plans to removes the tax free status is open to conjecture.

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 if, for example, 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.

This page 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 retire from an employers pension scheme where you have your own “investment pot”. These schemes are called defined contribution or money purchase schemes.  

You may also be surprised to hear that actually taking your benefits early can be more beneficial – please see our special page for information. 

What is an Annuity?

An annuity is a lump sum investment product sold by insurance companies. It is a way of converting capital, often from a pension fund built up during your working life, into an income for the rest of your life or, in certain instances, for the life of your partner too.  

An annuity is the most common method of obtaining an income from a pension. After taking any tax-free lump sum, you use the whole of the remaining fund to purchase an annuity. The annuity pays an income for the rest of your life. It's possible to convert only part of your pension to an annuity and delay converting the rest until a later date - you may wish to do this if you move from full to part time work as you approach retirement.  

Unlike other investments, it cannot be exhausted however long you may live. 

 Purchased Life Annuities

You may wish to use your tax-free cash or any other funds that you have built up to purchase this type of annuity. This is similar to a pension fund annuity, (also known as a compulsory purchase annuity), but is taxed more favourably and should therefore provide more income £ for £. Remember though, once you have purchased your annuity you cannot normally convert it back to cash.  

Open Market Option

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.

 Before shopping around make sure you understand what you already have on offer.

For example:

• 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?

 There can be a big difference between the best and the worst annuity rates. The company you choose can affect your income by hundreds of pounds a year and remember, you can’t change your mind later! You will usually be worse off in retirement than you need to be if you don't shop around for the best annuity. 

What size must my funds be to consider the Open Market Option?

Whilst there is no minimum actually required to exercise your open market  option, in practice there are unlikely to be any net benefits to you unless your funds are in excess of £30,000. For amounts less than this we would have to charge an additional fee for our advice, wiping out any potential gains that you might make.

Why are annuity rates a lot lower now than they were?

This is quite complex, but a number of factors have combined to bring this situation about:-

• We are all living longer. A few years ago an annuity taken out by a 65 year old man at retirement may have only been paid for 5 years before he died. Now, his life expectancy is probably 15 years more than it was then.

• Interest rates and inflation rates have fallen. These affect gilt rates with which annuity income is backed. A 10% annuity was quite feasible when interest rates were 8% and inflation 7%, but this is not the case now. If you wait, the situation could change – for better or worse!

• There is an element of “cross subsidy” with annuities. In short, those who die young benefit those who survive. With the advent of Unsecured Pension, this subsidy is likely to decrease as fewer people buy annuities. Unsecured Pension is not available to or suitable for, everyone, so an annuity may still be your best choice.

 Multiple pension funds?

If you have more than one pension fund then think about combining them when you are shopping around to buy an annuity ­as larger funds often attract better rates.

Types of Annuities

 There are different annuities to suit different needs. The main types are:-

• level

• increasing

• investment linked

 How annuities work

The amount of income an annuity will pay depends on:

• the amount that you have in your pension fund

• your age, sex and your health at outset

• the benefit options that you choose; for example, do you want to provide an income for your partner after your death?

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.

Usually, the starting income from the same size of pension fund is 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.

The income that you get at the start of an annuity is higher the older you are. You can usually choose for your income to be paid every month, every three months, every six months or once a year. This can be paid in advance or in arrears. There could be a tax advantage by choosing a payment in arrears depending on your tax position in the year of retirement.

 Enhanced annuities and impaired life annuities

Some companies pay you a higher income if you have a health problem or a lifestyle that threatens to reduce your lifespan. Relevant health problems could be, for example, cancer, heart attack, asthma, diabetes, high blood pressure.  Some of these conditions on their own may not be enough to qualify for an enhanced annuity. You may even qualify for higher rates if you are overweight or you are a regular smoker. It is estimated that up to 50% of people could benefit from an enhanced or impaired life annuity.

Level Annuities

A level annuity pays the same income each year for the rest of your life. The main drawback with a level annuity is that what you can buy with the income falls as prices rise through inflation

Level annuities pay a higher starting income  compared to increasing annuities. Think carefully about the effect of inflation. Could you really cope with having no increases at all in your annuity income during your retirement, which could last 30-40 years?

Escalating Annuities

To protect your income from rising prices, you can choose an annuity that is designed to increase each year. There are two main choices:

• escalating annuities - your income is guaranteed to increase at a fixed rate each year, commonly 3% or 5%.

• Inflation-linked annuities - your income is adjusted each year to reflect changes in the Retail Prices Index (RPI) - the main measure of inflation used by the government. So, if inflation is 3% one year, then your income goes up 3%. If inflation is 10% next year then your income goes up by 10%. However, your income is not guaranteed to increase each year - if the RPI did not rise, nor would your income.

With an escalating annuity, the starting income is a lot lower than you would get from a level annuity. For example, for a man aged 65, the starting income from a 5% escalating annuity might be two-thirds or less of the amount from a level annuity. It could take more than 10 years for the escalating income to catch up, and nearly 20 years before the total that you would have received from the escalating annuity exceeded the total from a level annuity.

Level or escalating?

You need to weigh up whether you think you will live long enough to benefit from the protection against inflation offered by an increasing annuity. Your income requirements may reduce as you become less active in older life and so a level annuity may work well for you in a low inflation economy, but should inflation dramatically increase you may find the purchasing power of your annuity reducing rapidly. We have developed a special forecasting tool which shows the difference between the income from both level and increasing annuities and calculates how long you would have to live before the increasing option is providing better value.

 Investment Linked Annuities

These offer the chance of a higher income in the future, but at the expense of taking extra risk.

These plans link to real assets such as fixed interest and equities, but you need to be comfortable with linking your income in retirement to the volatility of the stockmarket. They are therefore more risky than conventional annuities.

With-profits annuities

These link your income directly to the performance of the insurance company's with-profits fund. Typically, your income is made up of two parts:

• a minimum starting income - this is usually set at a low level but, unless investment conditions are very bad, you will usually get at least this much income. Some with-profits annuities guarantee it.

• bonuses - The insurance company usually announces bonuses each year. Bonuses can be 'reversionary' (usually announce once a year and guaranteed to pay out for the duration of your annuity) and 'special' - these only pay out a year or so until the next bonus announcement. The amount of any bonus depends on many factors, the most important of which is stockmarket performance. Some insurance company's may guarantee a bonus rate, for example 3% a year. Sometimes you can choose the guaranteed rate, but the higher the guarantee, the lower your starting income.

There are few companies offering with profits annuities now and their popularity has diminished following the introduction of Unsecured Pension.

 Unit linked annuities

Your income in retirement will be linked directly to the value of an underlying fund of investments. Generally, you can choose the types of fund, for example:

• medium risk managed fund where the fund manager selects a broad range of different shares and other investments - spreading your money widely reduces risk;

• higher risk fund where a fund manager selects shares and other investments in a particular country - Japan, say - or sector, such as smaller companies or technology companies. Because your money is less widely spread, the risk is higher;

• tracker fund (usually medium risk) which tracks the performance of a particular stockmarket index like the FTSE-100 (top 100 UK companies by market value). Usually, these have lower charges than managed funds.

Again, these have diminished in popularity since the introduction of Unsecured Pension

 Annuities if you have a partner

A single-life annuity pays out only during your own lifetime. A joint-life last survivor annuity pays out until the second person of a couple dies.

On the first death, some annuities carry on paying the same amount to the survivor. With others, the amount is reduced ­ for example, by a third or a half. You choose at the outset how much income you want the survivor to get.

With some pension schemes, it is the law that you must opt for an annuity that provides a pension for your widow or widower equal to half the income you were getting. Your provider can tell you if this applies to your plan or scheme.  

Annuities with a guarantee period

If you die soon after taking out an annuity, it will not have paid out much. To guard against this, you can choose an annuity with a guarantee period.

These sorts of annuity commonly guarantee to pay out at least five or ten years' worth of income, even if you die within this period. On your death, the income may continue to be paid for the rest of the guarantee period, or it may be paid as a lump sum to your estate (and inheritance tax might be due on it)

If anyone is financially dependent on you, do not look on a guarantee period as a substitute for a joint-life last survivor annuity. If you live to the end of the guarantee period, the survivors will get nothing.

 Value Protection - a new benefit should you die before age 75

People are often concerned they may not see the full value from their annuity if they pass a way in the early years - value protection means this eventuality is taken care of.

A lump sum can be paid out in the event of death before age 75 but you are also safe in the knowledge that income will be paid out for life, even if that is longer than you had planned for financially.

You can choose to protect up to 100% of the value of your pension fund. Adding value protection will reduce your pension income and you need to be sure that you can still meet your needs.

There are only a handful of providers offering this type of plan, so contact us for advice in the first instance.