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Bev Stoves & Sarah McCarthy, Independent Financial Advisers, Investment Sense

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A Lifetime Annuity is the only option which can guarantee an income for the rest of your life, however long that may be.

Historically, this is the most common way to take retirement benefits, taking the maximum tax-free cash sum available and using the balance of the fund to buy a Lifetime Annuity. The income is provided on a level or increasing basis for the rest of your life and is taxed as earned income.

Annuity rates are based on your age, health, life expectancy and the level of gilt yields at the time you buy your Annuity. Payments are made at agreed intervals, such as monthly or yearly, until your death.

You can buy your Annuity from the provider of your existing pension or shop about for a potentially better rate using the ‘Open Market Option’ facility, which you have to be offered. If you plan to buy an Annuity, it is crucial that you compare the Annuity offered to you by your current provider, with that which could be bought in the open market.

There are a variety of options which need to be considered, each of these options will have an impact on the Annuity rate and income you receive.

You can maximise income by limiting the number of additional options selected, however it is important that the options you select provide you with an Annuity which is suitable for your circumstances.

An Annuity with no options included will stop when you die and never increase in value. Any options selected at outset cannot be changed once the contract has been set up. You must consider these options carefully and understand that a Lifetime Annuity income cannot be altered in the future to match changing circumstances.

Income frequency

Typically, Annuity income is paid monthly. However, it is possible to have income paid at a different intervals, such as annually, half yearly, or quarterly. Income can also be paid at the beginning of each time period, or at the end, this is commonly known as ‘in advance’, or ‘in arrears’.

If income were to be paid annually in arrears, a slightly higher level of income would be payable than for an Annuity with income payable monthly in advance.

With and without proportion

This relates only to Annuity payments which are paid in arrears. For example, if an Annuity is paid annually in arrears and the annuitant dies at the beginning of the year, they will not have received their payment.

‘With proportion’ means that a proportional payment will be made for the percentage of the year in which the annuitant was living. Conversely, ‘without proportion’ means that no payment for that year will be paid. This has less of an impact where Annuity payments are paid monthly.

Guaranteed period

A Lifetime Annuity guarantees to pay an income for the rest of your life. However, including a guaranteed period means that if you die shortly after retirement, the full income continues to be paid to any beneficiary for the remainder of the guaranteed period.

For example, if you die after two years, the balance of the income due during a five year guaranteed period, i.e. three years, will be paid to your nominated beneficiary.

Typical options are to include a five or 10 year guarantee from the date of Annuity purchase. However, following recent changes to pension legislation, longer guarantee periods, of up to 20 or 30 years, to suit a variety of needs, are becoming increasingly available.

If you select a guaranteed period you should note that it does not start from the date of death but from the date the annuity is set up.

Overlap

‘Without overlap’ means that if the annuitant dies within the guaranteed period, the annuitant’s income is paid to the spouse / dependant, who will then receive their selected level of income from the end of the guaranteed period.

‘With overlap’ means that the selected spouse’s income starts immediately within the guaranteed period and the annuitant’s income also continues to be paid until the end of the guaranteed period. This means it is possible that more than 100% of the annuitant’s income could be paid out.

Indexation

If you wish to protect the real value of your income, it is necessary to include annual increases when you buy your Annuity.

Indexation is normally set at a fixed percentage, or at a level to match the Retail Price Index (RPI) with increases taking effect on the annual anniversary of the plan.

A level income is particularly exposed to inflation risk. This means that the buying power of your income will be impacted year on year, as the cost of goods and services rise.

Establishing an Annuity with an increasing income will have a significant impact upon the level of starting income, which is why most people chose to buy a level Annuity. There can be as much as a 30% reduction of initial income for including a 3% increasing income and up to 50% if RPI is chosen. This means consideration should be given to the amount of time needed to catch up with the income that would have been paid from a level Annuity.

Spouse’s / partner’s pension

If you are married, in a civil partnership or have a financially dependent partner, the Annuity can be set up to continue paying an income to them after you have died. Indeed, due to a change in the rules an Annuity can now be set up to pay the ongoing income to almost anyone you choose.

Following your death the income can continue at the full rate, or at a reduced level, generally, two thirds or a half.

Selecting this option will reduce your starting income, and cannot be changed. Therefore, if your partner dies before you, the Annuity terms will remain the same and the proportion of the purchase price used to buy the spouse’s pension will have been wasted. However, this option can provide valuable peace of mind.

Value protection

Including Value Protection means that if you die before the total income payments received are at least equal to the original purchase price, the difference will be returned.

A tax charge will apply, unless the money is reinvested in another appropriate pension income product, in which case the tax charge does not apply.

For example, if you purchased an annuity for £100,000 and died after only receiving £40,000 worth of Annuity payments, the difference of £60,000, less a tax charge, would be paid to your beneficiaries. However, if the £60,000 is used to purchase another pension income product, there would be no tax charge and the full £60,000 could be utilised.

Value Protection is currently only available until age 75. It is a less attractive option for those aged over 65 because they could choose to have their pension guaranteed for up to 10 years instead. For example, someone aged 70 could guarantee that their pension would continue until age 80.

Value Protection and Guaranteed Periods are mutually exclusive. You can have one or the other, but not both.


Where next?

Pensions Freedom – A summary of the key changes
Pensions Freedom – Key questions answered
Key considerations
Retirement options
Delay taking your pension
Investment Linked Annuity
Fixed Term Annuity
Flexi-Access Drawdown
Uncrystallised Funds Pension Lump Sum (UFPLS)
Full Encashment
Purchased Life Annuities
8 Steps to take leading up to retirement