Things to Take into Account When Buying an Annuity

Written by Karen Bryan

coinstackA lifetime annuity is a retirement financial product sold by insurance companies, which guarantees you a specified income per month or year until you die.

Some people are fortunate to be in a defined benefit pension scheme, where their pension is worked out as a percentage of their years of service and their final or average salary. However, if you have a money purchase, stakeholder, personal or NEST scheme, then the size of the pension which you will receive will depend on two things: the value of your pension pot and annuity rates.

Once you reach the age of 55, you have access to your pension. If you wish to receive a guaranteed amount for the rest of your life, you need to use the proceeds of your pension pot to buy a lifetime annuity.

Below are some things to think about when buying an annuity, along with my personal opinion, when I wrote this article in October 2013, followed by my experience when buying an annuity after my 55th birthday in April 2014.

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Shop Around for Your Annuity

One of the most important things to remember is that you don’t need to buy your annuity from the firm with whom you have your pension pot. There are annuity comparison websites, but they can charge a commission of around 3% if you purchase your annuity through them. The other issue with these sites is that they may not include all annuity providers. You can consult a financial adviser who looks at all annuity providers, but you’ll have to pay the adviser a fee. Paying a commission or fee could be worthwhile if it means that you get a higher pension income.

My view October 2013 – I’m planning to do the annuity research myself in the hope I can get a good payout without forking out on fees or commission. This could be flawed thinking, but last time we needed a mortgage I found a better deal than the mortgage broker.

My view May 2014 – It was impossible to avoid paying any fees or commission. When I approached annuity providers directly, I didn’t get a higher payout in exchange for them not having to pay any commission to an Independent Financial Adviser ( IFA) or broker. A commission of 1.3% of the value of my pension pot was deducted as commission by Annuity Line, the non-advised broker which I used. A similar amount was quoted in fees from the two IFAs I consulted.

At What Age Do You Plan to Take Your Pension?

Logic would say that the older you are when buying your annuity, the larger the pension you’ll receive, since you’ll have paid more into your pension pot and you’re likely to live for fewer years. But this isn’t always a the case. The size of your pension pot depends on the value of the stock market fund in which it’s invested, the price of which can fluctuate. In addition, the pension income that you can buy with your pension pot, depends on annuity rates at the time you purchase the annuity. Therefore, the aim is to cash in your pension pot when both the stock market and annuity rates are high; easier said than done.

Remember to factor in the years for which you won’t receive pension income when you look at annuity tables. For example let’s say compare retiring at 60 versus 65. With my pot, at 60 I’d receive an annual pension income of £2,500, at 65 it’d be £3,000. That extra £500 a year at 65 sounds good, but if I take that option compared to retiring at 60, I’ll lose five years of payments at £2,500 equating to £12,500.

However, it’s also possible that your pension income could be much higher by the time you reach age 65, if your pension pot achieved a good annual return over that additional five-year period.

My view October 2013 – I’m planning to stop paying into my stakeholder pension at the age of 55 and buy an annuity soon thereafter.  As I’m self-employed, my earnings aren’t guaranteed, so I’d like to have the certainty of an income for the rest of my life. I plan to keep working, at least part-time, until I receive my state pension aged 66.

My view May 2014 – Although changes to accessing personal pensions were announced in the March 2014 Budget, I decided that an annuity giving me a guaranteed RPI linked income for the rest of my life was the best option for me. I’m feeling under less pressure to earn money from self-employment, as I now have some secure income.

Check if There are Any Guarantees or Penalties

In the past, some pension funds offer guaranteed benefits which you may lose if you wish to access your pension pot before a certain or pre-agreed retrial age. There could also be penalties if you access your pension pot early. Make sure that you check for this before you start looking for the best annuities.

My view October 2013– There are no guaranteed benefits or early access penalties on my pension pot funds.

Are You Going to Take a Tax Free Lump Sum?

You can usually take a tax-free lump sum of up to 25% of the value of your pension pot. By taking a lump sum you know that you are definitely going to get some cash from of your pension pot. You may feel that you want to use the lump sum to treat yourself or your family. While it’s very tempting to have that cash, you have to weigh that up against having lower monthly/annual pension income for the rest of your life.

My view October 2013 – As the pension income derived from buying an annuity isn’t going to very large, I believe that my need for income is a much higher priority than cash.

My view May 2014 – I stuck to my decision not to take the tax-free lump sum. I could have taken the lump sum and used it to buy a Purchased Life Annuity (PLA) which would have given me a slightly lower income, but would have meant a lower tax liability. I calculated that my state pension plus my income from the annuity should equal my annual personal allowance when I reach state pension age at 66, meaning I should pay no income tax. The prediction is that I’ll live until aged 88, so I’ll be retired for 22 years paying no tax. I calculated that I was better to take the higher, but not so tax efficient, option of using 100% of my pension pot to buy a standard annuity.

Poor Health Can Mean a Higher Pension

If you health is poor, you may be able to get a higher payout. You need to ensure that you disclose your health details before buying an annuity.

My view October 2013–  I don’t have serious health issues which would merit to a higher pension income.

My view May 2014 – I did get a higher rate from an enhanced annuity through Partnership Assurance due to being overweight.

Do You Need to Make Provision for Your Family if You Die?

If losing your pension would mean financial hardship for your family, you need to look into preserving your pension payments after your death. If you wish your spouse/civil partner to receive a proportion of your pension on your death, usually called a joint life annuity, you’ll get a lower pension income.

My view October 2013 – My husband’s pension is high enough for him to live on, so we decided it’s better to have more cash now as a couple, so I’ll go for a single life annuity.

Do You Wish to Guarantee Payment for a Minimum Number of Years?

There’s often an option to guarantee payment of your full pension for either five or ten years, if you die during this period. When my husband bought a small annuity aged 57, his annual pension payment reduced by under £1 to get the five-year guarantee. However,  guarantees can be more expensive if you’re older or in poor health.

My view October 2013 – I’ll compare the pension income I’d receive with no, a five-year and a ten-year guarantee to make my decision.

My view May 2014 – I opted for a five-year guarantee.

Do You Want Your Pension Income to Retain its Spending Power?

Inflation is likely to erode the spending power of your pension. If you choose a level payment which stays exactly the same through your lifetime, your pension income will buy you less each year. But you will get a higher pension income immediately. This may be a good option if you retire early and need more income until you also start to receive your state pension. There’s often an option for an annual 3%, 5%, inflation, or Retail Prices Index (RPI) increase in your pension.

My view October 2014 – I’m planning on going for the RPI increase. I’m taking my pension early, so want to protect its buying power for later in life when I am less likely to be able to work.

My view May 2014 – I opted for RPI escalation. I was very tempted by the much higher level payout, but came to the conclusion that I wanted to preserve the spending power of my pension. There is a downside to this, as my annuity provider will decrease payments if there is deflation. Some annuity provider operate a ‘zero floor’ where they don’t reduce payments, but I didn’t get a decent quote from any of these providers. If I’d received a quote which was slightly lower, but offered a ‘zero floor’, I would have gone with it.

4 Responses to “Things to Take into Account When Buying an Annuity”

  1. I would invest in an annuity as a secondary retirement option, not primary. They are just a little bit too risky for me in my opinion.

  2. Doony – what would be your first retirement option? I reckon a final or average salary pension scheme but as I’m self employed, that’s not an option for me.

    I think an annuity is great once you’ve bought it i.e. guaranteed income for life. My issue is how to invest my pension pot until I want to buy an annuity and the annuity rates at that time.

  3. Really well put together blog, although I would point out a few additional things:

    1. “My view – I’m planning to do the annuity research myself in the hope I can get a good payout without forking out on fees or commission. This could be flawed thinking, but last time we needed a mortgage I found a better deal than the mortgage broker.” To be honest I think this is rather flawed. The mortgage and annuity markets are completely different. With mortgages there are certain deals / lenders not available to brokers, with annuities it works the other way around, there are some companies who will not deal with the general public. You also need to remember that if you go direct you will still pay commission. When it comes to buying an annuity there is no way of doing it without paying a fee or commission (not commenting on whether this is fair or not, just explaining this is the way it is). There is nothing therefore to lose by taking some advice; if you are paying a commission you might as well get something for it!

    2. Always use an IFA rather than a non-advised annuity broker. Yes, you will pay a fee, but in many cases this will actually be less than the commission charged by non advised annuity brokers

    3. Whilst the article goes into a wealth of detail on annuities anyone retiring should remember that the first decision isn’t what sort of annuity to have, how to buy it or to shop around. The first question should be whether an annuity is right in the first place? There are many many ways of turning a pension fund into an income, an annuity is only one; before you make your choice ensure you have considered all possible options

    4. Re tax free lump sums. If someone is a taxpayer and prefers to use 100% of the pension fund to produce an income, rather than taking the tax-free lump sum, there are two options. (1) Use 100% of the fund to buy a normal lifetime annuity or (2) Use 75% of the fund to buy a normal lifetime annuity and the 25% tax free lump sum to buy a purchase life annuity (PLA). A PLA benefits from preferential tax treatment and therefore can produce a higher net income. The options available on a normal annuity can be mirrored in a PLA. A good IFA will talk you through the benefits of this approach

    Just a few thoughts, hope other readers find them as interesting as the original article.

    Phillip Bray, Marketing Manager, Investment Sense

  4. Philip – thanks for your thoughts.