What is a pension annuity?
For those with a money purchase pension, when you reach retirement age, you will have a pot of money to use to generate an income. The most common options used are purchasing an annuity or a drawdown facility, or a combination of the two.
An annuity is a form of pension designed to give you a guaranteed income for life, therefore you will know what you are likely to get. You invest your pension pot into the insurance policy and in return, you get an income from the provider.
The amount of income is dependent upon annuity rates at the point where you purchase an annuity. Various other factors, like your health and what additional features you want to add to it, such as spousal income, will impact the amount that you will receive.
What are Annuity Rates?
Annuity rates determine the amount of income that you’ll get from your pension pot. It is a similar concept to interest rates as you will receive a percentage for the amount you have invested.
What is an annuity payment?
The present value of annuity pensions is normally expressed for every £100,000 invested. So, if the current annuity rate was 5%, then by investing £100,000 into an annuity, you would receive £5,000 per annum.
Annuity rates vary and are impacted by life expectancy, interest rates, gilt yields, and your health. Whilst your existing pension provider may offer an annuity, it is a good idea to shop around.
Seeking advice means that someone else can do the research for you.
What is a drawdown pension?
A drawdown pension involves placing your pension money into an investment which will continue to fluctuate depending on what the pot is invested into. You will then draw down from the pot to generate an income.
By taking an income from the pot, it is in theory, reducing. The funds remain invested to provide the pension money with the opportunity to grow and replenish some of the income taken. However, because it is constantly fluctuating, you could draw too much and run out of money in the future.
For some, the right answer may be a combination of the two. Others will initially start with a drawdown facility in the early years, before securing an income from an annuity in their later year.
No one size fits all so expert financial advice is essential before you make any decisions.
Annuity vs drawdown
| Annuity | Drawdown |
| The income you receive is guaranteed. | The income you receive is not guaranteed. |
| Most annuities will not allow you to change the income once this is set up. | A drawdown facility gives you the flexibility to change the income you draw as your circumstances change.
You can also choose to buy an annuity later with the remainder of your pension pot. |
| Health, age and lifestyle – impact the level of income you will receive.
Those with poor health may receive an impaired annuity rate. |
Health, age, and lifestyle in theory have no impact on the income that can be drawn.
However, a more decadent lifestyle could result in exhausting your pension pot. |
| There are no investment risks as the income is guaranteed. | There are risks to an investment-linked annuity as the pension pot could go down because of investment performance. |
| Once set up, an annuity has no ongoing costs. | There can be additional costs or charges associated with a drawdown pension. |
| Leaving a legacy – unless you pass away during a guaranteed period, then the pot will die with you. | Your beneficiaries will receive any money remaining in your pension pot when you die.
Should you pass away after the age of 75 years, the pot will be taxable. |
| Any income generated is taxed, like employment income, and is subject to income tax. | The same applies to a drawdown pension.
If you take a lump sum from your pension pot this is charged at your highest margin rate. |
A financial adviser would be able to tell you what is a good, guaranteed annuity rate. In both scenarios, you’re usually able to withdraw 25% of your pension tax free when you reach the age of 55. Though, this age limit is set to rise to 57 years in April 2028.
The options can be accessed before you reach your state retirement age, and receive your state pension, however.
What are the different types of Annuity?
When it comes to annuities, there are a wealth of different options to choose from.
Annuities can escalate each year or provide a fixed income. Some will provide a guaranteed period for which they’ll continue to pay an income to loved ones, even if you pass away.
Others might include a spouse benefit i.e., an income to your spouse of 100%, 50% or similar if you were to pass away.
Some examples of the types of annuities are:
1. Lifetime Annuity
This form of annuity will pay you a fixed level of income for the rest of your life. The pension pot is not subject to any investment risks and can provide peace of mind. Depending upon how long you live, you might get back less than you originally invested.
2. Fixed Term Annuities
This will provide a fixed income for a specified period, typically a period of 5 to 10 years. The annuity provider will then invest the money and traditionally, you will receive a “maturity value” at the end of the term. The maturity value is agreed upon when you take out the annuity, the lower the income the greater the maturity value is.
3. Enhanced or Impaired Life Annuities
Designed for those who have a lower life expectancy or health problems. Some companies will offer a higher annuity rate for those with a lower life expectancy, as they are wagering on not having to pay out the income for as long.
4. Investment-Linked Annuities
The income generated from this type of annuity is linked to the performance of the funds that it is invested in. Pension income may vary to reflect the changes in the value of investments.
Knowing which option is right for you
This is the million-dollar question for all beginning to think about retirement planning. As you can see, there are several different ways to generate income in retirement. The decision-making process will require asking tough questions like – do I want to know how much money I will receive every month?
Purchasing an annuity is a decision for life so making the right decision, is essential. By seeking financial advice, it helps to understand your goals and objectives for retirement. As financial advisers, our role is to understand your hopes, dreams, and aspirations, and guide you through the options and provide you with various solutions.
For more information, contact us today and discuss your financial options in more detail.
The value of an investment with St. James’s Place will be directly linked to the performance of the fund you select, and the value can therefore go down as well as up. You may get back less than you invested.
The levels and bases of taxation, and reliefs from taxation, can change at any time. The value of any tax relief depends on individual circumstances.
Income drawdown will reduce the size of your pension fund and the investment growth may not be sufficient to maintain the level of income you wish to draw. If you withdraw money at a rate greater than the growth achieved by your investments, your remaining fund will reduce in value. The level of income you take will need to be reviewed if the fund becomes too small – this is more likely the higher the level of income you take.
The income you receive may be lower than the amount you could receive from an annuity, depending on the performance of your investments. As annuity rates can change substantially and rapidly, there is no guarantee that when you do purchase an annuity the rates will be favourable. This could mean that your pension thereafter may be less than you hoped for.
The rules governing how much income you can take directly from your pension fund may change. This could mean that the income you can take from the investment no longer meets your requirements.
