Why annuities can still be useful in retirement planning
Why are annuities still relevant today? Despite the increase in pension flexibility in recent years, an annuity remains a fitting option for many people based on one certainty: The income is guaranteed to be paid for life.
What is an annuity?
A pension annuity is a contract in which you give up your pension pot fully or partially in exchange for a guaranteed regular income over a set term. There are two types: guaranteed income and non-guaranteed income.
|Lifetime annuity - level||A fixed amount per year that will not change for the rest of your life|
|Lifetime annuity - increasing||Income increases each year by a fixed percentage for the rest of your life|
|Lifetime annuity - index linked||Income increases each year in line with inflation for the rest of your life|
|Unit-linked annuity||Income is linked to the performance of one or more investment funds|
|With-profits annuity||Income is linked to a With Profits fund, giving the potential for annual bonuses|
The term for your secured income can vary from one year to an entire lifetime: if you only need guaranteed income for a short period, or you would prefer not to commit to a lifetime annuity then you do not have to exchange your pension pot in one go and can instead use part of your pension pot to purchase a short-term annuity.
What are the advantages of annuities?
Although you may prefer the control that options like flexi-access drawdown give, secure income from a pension annuity can provide an element of certainty in your retirement planning. So with all the options out there, why might an annuity be a suitable choice for you?
- You are not comfortable with investment risk, financial loss, or are otherwise cautious with your money;
- Your retirement provisions are insubstantial and you cannot afford for your pension value, and the income you receive from it, to fluctuate. This is referred to as having a low capacity for loss;
- You have the need for a guaranteed income, likely for a fixed and regular expense;
- You have little interest or desire to be “financially busy” or manage investments whilst in or approaching retirement;
- You have a particularly long life expectancy. The further into the future you look the cloudier it will be: annuities provide certainty here;
- Or, you have a lower life expectancy, perhaps caused by a medical condition.
What are the disadvantages of annuities?
Despite the security offered, as indicated above, annuities are disadvantaged as they are, generally speaking, quite inflexible. So why might an annuity be an unsuitable choice for you?
- Annuities are irrevocable, meaning once purchased, you cannot reverse the decision and get back your original pension fund.
- You lose the opportunity to access your pension flexibly, meaning on the pension fund you exchange for an annuity, you will lose any pension freedoms and you may not be able to draw pension benefits in the most suitable way for you.
- Annuity income is taxed as ordinary income, and because payments are secure, you could be forced into a higher tax bracket, depending upon other taxable income.
- Annuities have become increasingly complex of late. As annuity rates have been on a downward trend over recent years, providers now offer a range of colourful variations with multiple add-ons, fees and limitations, which has reduced their once famous simplicity. One of the core rules of financial planning is 'do not buy what you don't understand'.
- You can add different features to an annuity when purchasing one including indexing, or spousal survivor benefit, however this will likely be at the cost of the annuity rate given, and may reduce the annuity income you receive death benefits.
- Annuities cannot be used as an inheritance tool to pass down wealth to your children and grandchildren on you death. Unless you had included spousal survivor benefit, the annuity will cease on your death.
If you feel the advantages are more relevant then you may wish to use more of your pension pot to purchase an annuity to secure a greater guaranteed income, giving you peace of mind and less need to spend energy concentrating on your income in retirement.
If you feel the disadvantages are more relevant then a smaller portion of your pension can be used to purchase an annuity with a lower income (which may be all you need!). You can then utilise the bulk of your pension for investment or access via another means of retirement income.
What about your other retirement assets?
You need to consider your other assets that can provide you with retirement income and whether they are guaranteed.
Income in retirement can come from many sources other than a pension such as rental income via property, investment income, direct/company shares, inheritance, and of course, any cash reserves you have.
The amount of income these can provide you with, and to what degree said income is guaranteed can help build you a picture for your retirement provision and where a secured income can fit in.
A good starting point would be to determine how much income you would need on an annual basis in retirement and whether you would prefer a guaranteed or non-guaranteed option.
How are annuities taxed?
Annuity income is taxed as pension income, which is taxed at your marginal rate of income tax. Annuity income can make use of your personal allowance too (currently £12,570 for 2022/23) meaning, with your other income streams, you can receive this amount each year tax free.
When you purchase an annuity from your pension fund the cost of the purchase will be tested against your lifetime allowance if this is the first time you have accessed or drawn money from the pension plan (and just the growth is tested if the funds are already in a drawdown plan).
This may mean there is some tax to pay if you are over your allowance.
Remember: At retirement check what band of income tax you are in as this may have changed if you are no longer employed.
If you want more information on tax and pensions, take a look at our article about how to be tax efficient with your pension contributions.
How to choose an annuity?
You need to decide on the level of security you want as the main characteristic of a typical annuity is that the income is guaranteed.
If you want some investment exposure then you can purchase a unit-linked or with-profits annuity, however the income is non-guaranteed.
Once you reach the minimum pension age (currently 55 and it is intended that the minimum pension age will increase to 57 from 2028) you have the right to buy an annuity from your current pension provider or from the open market.
On deciding how an annuity can contribute to your retirement income, you then have full control over how the annuity is set up. You are able to decide:
- The frequency of income from monthly to annually; in advance or in arrears
- The term length that you receive guaranteed income
- Whether you want any annuity protection
- Whether you want any survivor’s annuity upon your death. This means you can secure a percentage of your annuity to be paid to a dependant or nominee
Remember: Annuities are irrevocable contracts: once in force they cannot be cancelled or reversed.
How much income can I get from an annuity?
There are three factors that determine how much income you can get: the size of your pension pot; your life expectancy and annuity rates (largely determined by gilt yields).
- The size of your pension: the bigger this is, the more income you can receive;
- Your longevity: the greater your life expectancy, typically the less income you are likely to receive. If you have a shorter life expectancy or medical condition then you can obtain a better annuity through what are referred to as impaired life or enhanced annuities;
- Annuity rates: the rate you will receive will be influenced by the former two points, however underlying rates are determined by gilt yields. The greater these are, the better rates that can be offered by insurance companies.
How much does an annuity cost?
Costs vary depending on the provider, however typically they are referred to as: Establishment fee (charged when the annuity is set up); Management fee (mainly where you choose an investment-linked annuity) and Insurance fee (for any guarantees with your annuity).
You may have to cover extra fees depending on whether there is any underwriting needed, or any adviser fees levied. TPO will clearly show any initial and ongoing charges in pounds and pence and, where necessary, explain why any alternatives have been discounted.
Without the right advice, it can be very difficult to firstly decide whether an annuity is the right option for you, and secondly to choose the best one. Why not arrange a free consultation with a Financial adviser today, who can help with annuity?