Annuities explained
What is an annuity?
What are annuity rates based on?
When can I buy an annuity?
What is a guaranteed period?
What is a spouse's pension?
What is escalation?
How often will my pension be paid?
What are 'Protected Rights'?
What is a 'Guaranteed Minimum Pension'?(GMP)
What is an enhanced annuity?
What is a 'With Profits' annuity?
What are the pros and cons of annuities?
Should I wait for annuity rates to go up?
What is an annuity?
Confusingly, an annuity is what many people would think of as a 'pension' – it pays you a regular income. When you decide to start drawing benefits from a pension fund, an annuity is the most popular way to do it. You can buy an annuity with any cash lump sum, but on this website we are only looking at conventional pension annuities. The concept of annuities is that you exchange a lump sum (in this case, your pension fund) for a guaranteed income for the rest of your life. Once you have purchased the annuity it cannot be altered or converted back into a lump sum. This is why it is so important to make the right decisions – you only get one chance. The benefit of doing this is that you have no further worries about investment risk, which is something that you probably won't want to deal with as you get older. If you rely on the interest from cash savings for your income, then you can be caught out if interest rates fall dramatically, as they have done recently. Annuity income is fixed for life.
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What are annuity rates based on?
The annuity rate is the rate the insurance company uses to determine how much income they will pay you in exchange for your pension pot. If you have a pension pot of £100,000 and they exchange it for an income of £6,000 per year gross, this represents an annuity rate of 6%. One factor determining what annuity rate you get is their estimation of your mortality – how long you will live. This means that annuity rates for women are lower than those for men (because women live longer). Annuity rates are also lower for younger people, for the same reason. Conversely, if you have health problems or you are a smoker you can get an enhanced annuity rate based on your lower life expectancy. Because people are generally living longer due to improvements in medicine, there is an ongoing downward pressure on annuity rates which is likely to continue. The other main factor is interest rates, or more accurately long gilt yields. This is the yield or interest rate payable on long term government bonds, or 'gilts'. Gilts are used by the insurance companies as an investment to produce the required income to pay their annuitants. If the income payable from gilts is lower, then annuity rates will tend to fall.
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When can I buy an annuity?
You can currently buy an annuity with your pension fund from age 50. With effect from 6 April 2012, the age limit will rise to 55. Under current legislation you can delay your annuity purchase until age 75 at the latest.
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What is a guaranteed period?
As it sounds, this is a time period within which your annuity will continue to be paid, even if you die prematurely. So a 5 year guaranteed period will ensure 5 years' worth of annuity payments. After the guaranteed period ends, the annuity will still continue to pay until the annuitant dies. The possible maximum guaranteed period is 10 years. For all but the most elderly, this is a relatively inexpensive option to add to your annuity, and it will ensure that your surviving family would continue to benefit from your pension if you died prematurely. For those with no surviving family, this would be less of a priority.
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What is a spouse's pension?
As it sounds, this ensures that your surviving spouse would continue to receive income from your pension after your death for the remainder of their life. Spouse's pensions are commonly selected as 50%, 66% or 100% of the original pension. The cost of a spouse's pension varies, and is dependent on the relative ages of the two annuitants. The option would tend to be cheaper on a woman's pension, (providing a spouse's pension for her husband) because statistically the husband is more likely to die first. If the spouse dies while the pension is in payment, the spouse's pension option would have been wasted and the annuity would just cease on the death of the annuitant (unless they had remarried, in which case some annuities will pay out to the new spouse). If you combine a spouse's pension and a guaranteed period and the annuitant dies within the guaranteed period, the spouse would get the full pension for the rest of that period and then the reduced spouse's pension would commence.
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What is escalation?
This is a term for a pension which increases each year. The idea of this is to combat the effects of inflation and to maintain the buying power of your pension over the years. You can ask for your pension to increase in line with the Retail Price Index (RPI) each year, or it can increase at a fixed rate (3% or 5% each year are the most common). The problem with an increasing pension is that it drastically reduces your initial annuity in comparison with a level annuity. For a 3% increasing annuity, you would currently have to survive for at least 15 years before your increasing annuity had caught up with the income you would have received from a level pension.
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How often will my pension be paid?
You can usually specify that your pension be paid monthly (the most popular), quarterly, half yearly or annually. The payments can be in advance (with the first payment coming immediately the annuity starts) or in arrears (monthly in arrears would start after 1 month). This has a small effect on the annuity rate offered, more so if the payments are less frequent.
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What are 'Protected Rights'?
This is a part of your pension fund which has built up as a result of payments from the DWP, usually because you have 'contracted out' of the earnings-related part of the State Pension, known as S2P or SERPS. Protected Rights have special rules attached which makes them slightly different from the rest of your pension fund. They have to be paid out using unisex annuity rates – in practice this means slightly worse rates for men (and better rates for women) than they get on their main pension fund. Protected Rights annuities have to include a 50% spouse's pension if the annuitant is married. They can only have a maximum guaranteed period of 5 years. Other then this, the rules are the same when buying your annuity with normal or 'Non-Protected Rights' pension funds. Some enhanced annuity providers do not accept Protected Rights funds.
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What is a Guaranteed Minimum Pension? (GMP)
GMP benefits arise when you have been a member of an occupational pension scheme that was contracted out of SERPS before 6 April 1997. Instead of building up a SERPS pension alongside your basic state pension, you paid reduced NI contributions and the scheme promised to provide an additional pension which was meant to mirror the State benefits you gave up. If you were in one of these schemes, or if you have transferred out of one and into a Section 32 Buyout Bond, there will usually be a Guaranteed Minimum Pension which the pension provider must honour at state retirement age, irrespective of the fund value and annuity rates at that point in time. If the fund value at retirement is insufficient to cover the GMP, then you will not be able to draw any of the fund as a tax-free lump sum.
The GMP is only guaranteed at state retirement age. If the fund is insufficient to provide the GMP before then, then you will be unable to draw benefits early.
In the case of a Section 32 Buyout Bond, you might be able to transfer into a Personal Pension prior to retirement. On transfer to a Personal Pension, GMP benefits are converted to Protected Rights. The guaranteed pension amount is lost, but it should enable the usual 25% to be drawn as a tax-free lump sum. This can be advantageous to some, but you should always take advice before giving up a guaranteed pension.
Pre 6/4/1988 GMP benefits have to provide a 50% spouse's pension. Post 6/4/1988
GMP benefits have to provide a 50% spouse's pension and also must increase
in payment by the lesser of RPI and 3% per annum.
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What is an enhanced annuity?
Certain people can get a better annuity rate from specialist annuity providers based on their state of health. The logic is simple – if you are in less than perfect health then you are not likely to live as long so the company will offer a better annuity rate for you. You need to provide health details, and the annuity provider will underwrite you and offer an annuity rate. This can get you a rate that is 25% or more higher than the best standard annuity. These are becoming more and more popular, because even those with minor conditions like high blood pressure, obesity, or high cholesterol can get a better rate. The downside of this for healthy annuitants is that it will tend to drive down annuity rates for them. The reason for this is that unhealthy annuitants who take a standard annuity and then die early are currently subsidising the annuity rate for healthier individuals who live longer than average. If more of the unhealthier people are segregated into enhanced annuities then this subsidy will have a lesser effect, pushing down standard annuity rates.
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What is a 'With Profits' annuity?
A With Profits Annuity is a standard annuity with an investment element included. This means that your annuity income can vary from year to year depending on the performance of the underlying With Profits fund. At the start of the annuity you select a target growth rate. If the bonus rate declared on the underlying With Profits fund exceeds this growth rate, then your annuity income will increase. If the With Profits bonuses are lower than your chosen growth rate, your annuity income will fall. With Profits bonus rates are linked to the stock market - in bad years the fund might announce a 0% bonus rate.
If you choose a high target growth rate at outset, your initial income level will be higher, but the chances of maintaining it are lower. You can change the target growth rate which gives you some income flexibility.
With Profits annuities are suitable for those who are prepared to accept some variation in their retirement income, in exchange for the potential for growth. They are also an option for those who are concerned about future inflation, but do not think that the rates offered on increasing annuities are very generous. If you cannot face the possibility of your pension income falling, then a With Profits annuity is not for you.
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What are the pros and cons of annuities?
An annuity is a very old concept that still works. You pay a lump sum of money (in this case, your pension fund) which then provides you with a very low risk, guaranteed income for the rest of your life. Even if your annuity provider went out of business, your annuity income would be protected by the FSCS (Financial Services Compensation Scheme).
This means that you have no future worries about how your investment is performing, and you can rely on that income for the rest of your life. You can also include options like guaranteed periods, increases and spouse's pensions to provide extra security for your family and protection against inflation.
Probably the main disadvantage of annuities is their inflexibility. Once you have purchased your annuity, you cannot make any alterations to it. This means that if your circumstances change in the future, you might wish you had selected different options. This is why it is important to understand all the possibilities before you make the decision.
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Should I wait for annuity rates to go up?
This is a common question. There is sometimes a perception that annuity rates are at a low and that they might recover in the future, making it worthwhile to delay your annuity. There are several factors that determine annuity rates. One major factor is longevity. As people are living for longer, annuity rates are being forced downwards. This is a trend that is likely to continue due to improvements in health and medicine. The increased popularity of enhanced annuities (for smokers and those with medical problems) will force down standard annuity rates. Finally, low interest rates and low gilt yields also put a downward pressure on annuity rates. Standard annuity rates have been on a gradual downward trend since 1995. They do go up and down from month to month but the general pressure is downwards. If you delay taking your annuity, you are missing out on income. You need a good reason to give up this income, especially if you have retired or are nearing retirement.