If you have a money purchase pension, be it a personal pension or a company pension, when you finally decide to retire you will need to use what is left of your accumulated pension fund to by a lifetime annuity.
An annuity is a contract between an insurance company and a pension scheme member. Under the terms of the agreement the member gives all or some of his/her accumulated pension fund to the insurance company. It in turn agrees to give the member regular pension income for rest of the holder’s life (or their spouses if it is a joint policy).
It is important to realise that once you have bought an annuity all of the money in your pension fund will have been exchanged for an income for life. You cannot pass on your annuity on your death (although you can take out a joint life policy which will provide some income to your spouse/partner on your death or opt for a guaranteed period – see below). Once you have bought your annuity it cannot be change, so it is crucial that you buy the right one.
How annuities pay out
The amount of pension income an annuity will pay depends on a number of factors. This includes:
The value of your pension fund after you have taken your tax-free lump sum,
Your age, as the younger you are the longer you will need income,
Your gender, given that women generally outlive men,
Your health and lifestyle, so you may be able to get an enhanced annuity (see below),
The benefits you select for your annuity, such single or joint life and annual increases, plus
Other factors such as inflation and the yield on Government bonds can also affect annuity rates and can push annuity rates up or down.
What happens on retirement
Shortly before you are due to retire your pension scheme provider will write to you informing you of the value of your pension fund. They may also give you a quote for an annuity, which will be based on a basic single life, level (no increases for inflation) annuity. However, you should find out about other annuity options so you can make an informed choice, known as the open market option.
When it comes to buying an annuity it is vital to understand your needs and priorities. There are several types of annuities and it is important to get the right one for your needs.
Firstly you need to decide if you want a single or joint life policy. You’ll get more income with a single life, but there will be no provision for your spouse/partner on your death.
You could go for a guaranteed period which will pay out for a guaranteed period (usually five or ten years) so that your loved ones still get some benefit from your pension savings even after your death.
You will also need to consider whether you want your annuity to provide a level income or have it increase a bit each year, for example to cover inflation.
If you are in ill-health or are a smoker you may want to consider an enhanced rate annuity. These will give you a larger pension income (usually at least 30% more) to reflect your shorter than average life span. So take your heath into consideration when shopping for an annuity.
There are other retirement options, such as income drawdown [link to ID], which allow you to keep some or all of your pension savings invested and draw off income from the fund. Once you reach age 75 you’ll need to buy an annuity, but this may be an option for some individuals.
It is important to realise that the annuities offered by your pension provider may not be the best one for you. Equally annuity rates can vary dramatically depending on the type of annuity benefits you want and the provider. A joint life, with increases for inflation will cost more to provide than a single life, level annuity, so the amount of pension income you’ll receive will be less.
It is vital for you to shop around for the best annuity for your needs. This may require a lot of paper work and form filling but as your future depends on getting it right, you should find this as time well spent.
As buying an annuity is one of the most important financial decisions you will ever make, you may want to get professional financial advice and guidance.
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