Annuities Explained

by Adam on April 11, 2013

Annuities can be a complicated, but, in short, they are a way to turn a lump sum into a regular monthly income. They are  insurance products and are most commonly used to make sure you don’t run out of money when you stop working.

If you are nearing retirement you have some options to consider:

 

You don’t have to convert your pension pot into an annuity when you stop working

If you have other savings outside of your pension, such as a Stocks and Shares ISA or Brokerage account, you could live off that money and let your pension pot continue to grow. It can be worth delaying using your  your pension pot, especially if you retire early. The older you are when you take out an annunity, the more income you will receive per year, typically.

 

In fact, you don’t have to convert to an annuity at all, thanks to new rules by the UK Treasury

Before 2011 you would have been forced to convert your pension pot into an annuity at age 75. But now, instead you can consider ‘income drawdown’, which allows yearly withdrawals between £0 and 100% of the basis amount of the pension fund, (the % allowed per year depends on your age). This option allows you to keep your money invested in the markets for potential further growth, rather than being forced to buy an annuity at a certain time (which locks in your level of income). The capped drawdown limit is reviewed every 3 years before age 75 and every year thereafter.

And if you can verify that you have a guaranteed lifetime income of £20,000 per year,  there is also an new flexible drawdown option which will allow withdrawals above the capped drawdown limit.

Sources of income which count towards the guaranteed lifetime income required are state pensions, defined benefit pension schemes, scheme pensions and lifetime annuities.

 


When you get an annuity, you can take a tax-free cash lump sum

You can take up to 25% lump sum of your total pension fund when you purchase an annuity. This can be good because that lump-sum money has never been taxed and never will be. It wasn’t taxed when you put it into the pension, and it doesn’t get taxed when you take it out.

That’s a rare deal!

But it’s important to note that taking out a lump sum reduces the amount your annual income will be because it reduces the pension pot value which is is buying the annuity.

 

Factors that affect the level of income an annuity will provide:

  • The size of your pension fund (and if you have reduced it with a tax-free lump sum)
  • Age: the older you are, the more income you will receive from your annuity.
  • Health and lifestyle:  You may be entitled to enhanced annuities. As an annuity is a form of insurance,anything that will increase the odds that you dying early ‘enhances’ what your annuity pays. Examples include diabetes, smoking habit, and a Body Mass Index of 36 or more.

 

The most important things to know:

Once you’ve signed an annuity contract, you can’t change your mind, but before you have signed you can shop around for the best rates – you are not limited to the annuity option presented to you by your pension provider. It’s also worth noting that using your pension pot for an annunity means you won’t be able to pass it on to your heirs – the capital is gone forever.  If you wish to leave an inheritance it’s worth keeping some of your savings outside of an annuity.

The annunity provider is making a bet that you’ll not live long enough to receive all your money back, otherwise they would not be able to afford to keep providing an income for those who live a long life and receive more than they put in.

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