An Annuity is the most common way in which to turn the pension fund into which you have been savings throughout your working life into an income. When you retire your pension needs to replace your earned income and this is achieved by purchasing an Annuity.
A pension annuity will provide you with an income throughout your retirement irrespective of how long you live. The income will be based on the size of the pension fund which you have built up throughout your career. You can take 25% of this as a tax free lump sum and the remainder must be taken as an income.
The annuity is purchased with the sum which you have built up in your pension fund. However you are not obliged take an annuity from your existing pension provider. You have the right to shop around using the Open Market Option.
The way you receive your income is up to you. Some of the choices include
A Level Annuity is the most popular option. It provides a set level of income year after year which does not change. It has the advantage of providing a higher level of income in the early years in comparison with an annuity which increases each year. The major disadvantage, however, is that your income will not increase as the cost of living increases.
An Increasing Annuity rises each year, as opposed to a Level Annuity, which stays the same. The advantage is that over time, as the cost of living increases, so does your income, allowing your money to keep its real value. The disadvantage is that in the early years you will receive a smaller income than one from a Level Annuity.
There are two main way to increase your income;
1) An RPI linked annuity which increases your income in line with the Retail Price Index ( the common measure of inflation )
2) An Escalating Annuity, which rises at set levels each year.
To keep your income in line with the real cost of living, an RPI Annuity links your income to the official measure of the increasing cost of living. RPI or Retail Price Index measures a basket of goods and services which the typical person would buy. As this measures the actual increase in the cost of living, it effectively inflation-proofs your income, meaning that it keeps its real spending power.
Inflation can erode the real value of your monthly income. Over time the cost of goods generally increases. If your pension income is not increasing at least in line with inflation, you will be able to buy less and less. To mitigate against this, an Escalating Annuity increases each year at a pre-determined level. This means that your income will increase year on year at a set rate, allowing you to maintain your standard of living. The disadvantage, however, is that in the early years your income will be less than if you had chosen a Level Annuity.
An Enhanced Annuity takes into consideration factors which may affect your life expectancy. An Enhanced Annuity is designed to provide more income in the early years of retirement. Factors such as whether you smoke, take medication or have been hospitalised in the past can affect the income you receive. It is estimated that around 40% of retirees could increase their income through an Enhanced Annuity.
A Single Life Annuity provides income to one person only. If the annuitant dies the payments usually cease (unless they die within a Guaranteed Period which continues to pay out for a limited number of years). This may be suitable if you do not have a spouse, partner or anyone who is dependant on your income. The income will be higher on a Single Life basis than on a Joint Life Annuity.
A Joint Life Annuity covers two parties, and will continue to pay out to the remaining spouse or partner for the rest of their life. This option is more expensive than a Single Life Annuity as it is doubling the risk to the insurer. It is often used for couples where one party may have no pension savings, and they therefore effectively share the pension.
- Guaranteed income, you know your income from day one until the day you die
- You may be entitled to an enhanced rate increasing the income you receive
- Simple product
- Not exposed to any investment risk
- Annuity rates have decreased over the last 20 years, as we now live longer
- You cannot change your mind
- Expensive to ‘bolt on’ options such as a spouse’s benefit or 10-year guarantee
- When you die so does your annuity income
- Your income will probably not provide the same purchasing power in 15 years’ time if you choose a level annuity, as the cost of living is likely to increase.