There has been a lot spoken about annuities over the years, but many people are still unsure exactly what they are. For anybody with a pension, whether to purchase an annuity or not is a big decision, and something which pension companies will push – but what are they exactly?
Why do annuities exist?
Despite what many people have been led to believe, a pension does not automatically supply you with an income during your retirement. Ultimately, the pension you’ve been paying into for a number of years is actually just a pot of money. When you retire, the premise is that you then use that pot of money to buy a product to supply you with an income during your retirement, rather than taking an income directly from the pension pot itself.
An annuity is one such product.
For many people, an annuity is the default product which they will purchase from their existing pension provider without reviewing all their options. An annuity is just one way of taking your retirement income, but there are other options, and also multiple types of annuities.
What is an annuity?
When you want to start withdrawing your pension, you first need to turn it into an income.
An annuity is a financial product which you purchase from an insurance company which does exactly that. Once purchased, your annuity will provide you with a regular income for the rest of your life.
The way that an annuity is sold is that it will be a percentage of your total pension pot. Therefore, if you’re offered an annuity rate at 5% and you have a pension pot of £500,000, you will receive £25,000 per year as an income for the rest of your life.
Who is eligible to buy an annuity?
Annuities can be purchased by anybody with a personal pension or a defined contribution workplace pension. With other types of pensions, such as defined benefit or final salary, your income is paid directly to you and as such there’s no need to purchase an annuity.
For British expats with QROPS or QNUPS, while it may be possible to purchase an annuity, in most cases there is no need as you can draw your income directly from the scheme. These schemes also offer benefits around estate planning and inheritance tax.
Annuities are also not applicable for state pensions.
Where can I buy an annuity
Annuities are sold by an insurer who offer you a fixed income for the remainder of your life. As with any insurance which is not required by law, in some ways it’s a gamble. The key thing to remember is that once you have made your decision, you do not have the chance to change your mind afterwards.
Therefore it is key that before you make any decisions you seek independent advice to ensure you have uncovered all of your options.
As with any company trying to sell you something, often what looks good in principle may have a catch.
When can I buy an annuity?
Up to six months before you are due to retire, you will receive some information from your pension provider giving you information about the value of your pension and the annuities available. They should also clearly explain the benefits of shopping around. A report produced by the FCA in February 2014 highlighted that this was not being communicated enough and that more often that not, people were simply not aware they could shop around.
Over the next few months you will be asked a series of questions before you get to choose your annuity. Much like health insurance, these will give the annuity provider information about your lifestyle, enabling them to estimate your expected remaining life span.
Benefits of purchasing an annuity
The major benefit of purchasing an annuity is that it provides you with a guaranteed income. Typically, your income will not be impacted by external factors which allows you to plan based on the known income for the rest of your life.
If you choose the right annuity, you may also not be affected by inflation as the actual income you receive will be set to rise with inflation, thus ensuring that rises in the cost of living are also more closely met.
If you have health issues, you may also benefit as an insurer is likely to offer a higher annuity rate due to your lower life expectancy. This can be as much as 60-65% more.
Of course, if you live longer than your life expectancy, you may actually find that your total income is actually greater than your final pension pot.
Drawbacks of purchasing annuities
Once you’ve purchased your annuity, that’s it. You cannot ever change your mind. This is why seeking advice and shopping around is so important. Once your annuity is purchased, the income for the remainder of your life is set.
This exposes another major drawback. You also cannot leave anything behind for your loved ones. This means that if you die before you’ve received your full pension, the rest of the pension pot stays with the insurer.
Annuity rates, just like interest rates, fluctuate all the time and are not solely based on your personal situation. Much like with a mortgage, you only have a small window of time to make your decision and if the economic situation is not well set, you could find yourself stuck with a lower annuity rate than if you retired a few years earlier/later.
I’m an expat, do I still have to purchase an annuity?
If you are an expat, you can still purchase an annuity. However, there are also options available for you which mean you don’t have to purchase an annuity.
Making a decision about an annuity
The biggest danger with annuities is not being aware of all your options. Your pension provider is keen to sell you annuities through them and will obviously make them attractive.
You should never make a decision about whether to, or which annuity to purchase without at least reviewing the full market and getting a range of quotes.
Getting advice vs not getting advice
Always remember that when you purchase an annuity most of the time it cannot be altered once it’s in place. Therefore it’s vital that you seek independent advice to ensure that all potential options and products have been explored before you make a decision.
If you are an expat, it is even more important to seek advice due to the additional options of offshore financial products which are not always communicated by your UK pension provider or adviser. The initial consultations are nearly always free and have no obligation, so the risk of exploring your options is minimal – especially when the trade of is peace of mind for the rest of your life.