Having saved hard to build up a pension fund, there will come a time when you need to think about turning your savings into a retirement income. The conventional way is to buy an annuity.
Annuities provide an income in exchange for a capital sum. When you swap your pension fund for an annuity you usually buy a compulsory purchase annuity. In this article we take a look at the different annuity options.
How does an annuity work?
Just as life assurance offers protection against the financial consequences of ‘dying too soon’, annuities protect you from running out of capital through ‘living too long’. The income you receive from your annuity depends largely on the size of your pension fund, your age and gender, and the type of annuity you choose. Annuity rates vary in line with movements in interest rates and bond yields.
Single-life or joint-life?
First, you will need to choose either a single-life annuity or a joint-life annuity.
A single-life annuity pays you an income until you die, and then stops. A joint-life annuity pays an income that continues after you die to a surviving partner or dependant.
What Annuities are available?
There are different annuities to suit different needs.
A level annuity pays the same income each year for the rest of your life. The main drawback is that, as time passes, inflation reduces the buying power of your income.
As the name suggests, an increasing annuity protects your income from rising prices by increasing each year, either by a fixed percentage or in line with prices. At first, an increasing annuity pays a lower income than a level annuity.
Linking your annuity to movements in the stock market, or insurance company investment funds offers you the opportunity of a higher income in the future. However, the reverse is also true and you risk your income reducing if stock markets go down.
This is similar to an investment-linked annuity except you link your income to an insurance company’s with-profits fund. Your future income depends on the insurance company’s capacity to pay bonuses.
You can choose to add a guarantee to your annuity. This means if you die during the period of the guarantee the payments continue to your estate until the end of the guarantee period. Adding a guarantee will reduce the income you receive from your annuity.
When you take out life assurance, poor health may mean it costs more because of the heightened risk of you dying and the policy paying out. This same logic applies to an impaired-life annuity.
An impaired-life annuity pays a higher income if poor health means it is likely the annuity won’t have to pay the income for as long as it would to a healthy person.
As well as impaired-life annuities, there are annuities that pay a higher income to smokers because of their shortened life expectancy.
Open Market Option
Although you may have built up your pension fund with a particular company, this does not mean you have to buy your annuity from them. This is where the open market option is useful as it allows you to take your pension fund to the ‘open market’ and buy your annuity from the company offering the best income.
The government is concerned about the low take up of the open market option and believes too many people just take the first annuity on offer. The government plans to reform the open market option process to ensure everyone has the opportunity to maximise their retirement incomes.
Small Pension Funds
If your total pension funds, including the capital value of any pensions you are already receiving, do not exceed £18,000 in the 2011/12 tax year, you can choose to receive your pension funds as cash. One quarter of the cash sum is tax-free with the balance taxed as income in the year you receive it.
As you can see, you have several annuity options when you retire. However, with this much choice, it is essential that you take independent financial advice so that you make the right decisions. As a bookkeeping organisation we work closely with some good Independent Financial Advisors and Accountants and can arrange reviews with them on your behalf – we receive no financial reward or any form of commission for doing this as we see it as part of our remit to help you and your business.