Annuities Explained

The open market option
What exactly is an annuity?
How are Annuity rates calculated?
When and where can I buy an annuity?
What is a guaranteed period?
What is a spouse’s pension?
What are the costs of features like spouse”s benefit and protection against inflation?
What is escalation?
How often will my pension be paid?
What are ‘protected right’?
What is an enhanced annuity?
Should I buy an Investment-linked Annuity?
What is Annuity protection lump sum death benefit?
What if my pension funds are small (less than £17,500)?
What if I have more than one Pension Fund?

Most individual pensions do not normally start paying you an income when you retire. Instead you can choose when to start taking the income from your pension between age 55 and 75.

Part of your pension can normally be taken as a tax-free lump sum usually 25%. The remaining 75% of your fund can then be converted into an annuity which pays you a taxable income for the rest of your life. Annuities are provided by insurance companies. The company that you choose promises to pay you a regular income in exchange for your pension fund, no matter how long you live.

Once set up, the terms of your Annuity are fixed and offers a secure income. You can rest safe in the knowledge that your income will never run out. However, because the income is fixed it is important to choose your options very carefully, because once it is set up you cannot change your mind.

The Open Market Option – your right to shop around

You rarely have to stay with your existing pension provider when you retire and often they will not offer you the best annuity income – Like Banks they rarely offer their existing customers the best rates and the difference between the best and worst annuity rates can be substantial.

You can get more from an annuity if you shop around. You may qualify for what is known as an Enhanced Annuity (sometimes known as an Impaired Life Annuity). This pays a higher income to people who suffer from a range of health conditions – anything from asthma to heart disease, cancer or stroke or if you smoke or live in certain postcodes . Additionally, higher rates are sometimes offered to people who have retired from certain occupations or people who live in certain parts of the country.

When setting up your annuity the choices you make are important and cannot be changed once it is set up. You should consider both your immediate and long-term needs carefully when making your decisions as well as those of any dependents.

What is an annuity?

Confusingly, an annuity is what many people would think of as a ‘pension’ – it pays you a regular income. When you decide to start drawing benefits from a pension fund, an annuity is the most popular way to do it. You can buy an annuity with any cash lump sum, but on this website we are only looking at conventional pension annuities. The concept of annuities is that you exchange a lump sum (in this case, your pension fund) for a guaranteed income for the rest of your life. Once you have purchased the annuity it cannot be altered or converted back into a lump sum. This is why it is so important to make the right decisions – you only get one chance. The benefit of doing this is that you have no further worries about investment risk, which is something that you probably won’t want to deal with as you get older. If you rely on the interest from cash savings for your income, then you can be caught out if interest rates fall dramatically, as they have done recently. Annuity income is fixed for life.

How are Annuity rates calculated?

The annuity rate is the rate the insurance company uses to determine how much income they will pay you in exchange for your pension pot. If you have a pension pot of £100,000 and they exchange it for an income of £6,000 per year gross, this represents an annuity rate of 6%. One factor determining what annuity rate you get is their estimation of your mortality – how long you will live. This means that annuity rates for women are lower than those for men (because women live longer). Annuity rates are also lower for younger people, for the same reason. Conversely, if you have health problems or you are a smoker you can get an enhanced annuity rate based on your lower life expectancy. Because people are generally living longer due to improvements in medicine, there is an ongoing downward pressure on annuity rates which is likely to continue. The other main factor is interest rates, or more accurately long gilt yields. This is the yield or interest rate payable on long term government bonds, or ‘gilts’. Gilts are used by the insurance companies as an investment to produce the required income to pay their annuitants. If the income payable from gilts is lower, then annuity rates will tend to fall.

When can I buy an annuity?

You can currently buy an annuity with your pension fund from age 55. Under current legislation you can delay your annuity purchase until age 75 at the latest.

What is a guaranteed period?

As it sounds, this is a time period within which your annuity will continue to be paid, even if you die prematurely. So a 5 year guaranteed period will ensure 5 years’ worth of annuity payments. After the guaranteed period ends, the annuity will still continue to pay until the annuitant dies. The possible maximum guaranteed period is 10 years. For all but the most elderly, this is a relatively inexpensive option to add to your annuity, and it will ensure that your surviving family would continue to benefit from your pension if you died prematurely. For those with no surviving family, this would be less of a priority.

What is a spouse’s pension?

As it sounds, this ensures that your surviving spouse would continue to receive income from your pension after your death for the remainder of their life. Spouse’s pensions are commonly selected as 50%, 66% or 100% of the original pension. The cost of a spouse’s pension varies, and is dependent on the relative ages of the two annuitants. The option would tend to be cheaper on a woman’s pension, (providing a spouse’s pension for her husband) because statistically the husband is more likely to die first. If the spouse dies while the pension is in payment, the spouse’s pension option would have been wasted and the annuity would just cease on the death of the annuitant (unless they had remarried, in which case some annuities will pay out to the new spouse). If you combine a spouse’s pension and a guaranteed period and the annuitant dies within the guaranteed period, the spouse would get the full pension for the rest of that period and then the reduced spouse’s pension would commence.

What are the costs of features like spouse”s benefit and protection against inflation?

The annuitant can add extra features to a pension annuity depending on their requirements. The following table shows the costs associated with a number of main features, assuming that the annuitant and spouse are 65 years old, the income is on a level annuity basis paid monthly in arrears, no guaranteed period included and is without proportion. The cost of the added features will reduce £1,000 of pension income per year by the stated amounts.

Cost per £1,000 of pension income

Features Female 65 Male 65 Joint 65
With proportion £2 £2 £2
Advance payment £6 £8 £5
Guaranteed for 5 years £6 £9 £5
Guaranteed 10 years £25 £37 £19
Survivors pension 50% £64 £108 n/a
Survivors pension 66% £7 £140 n/a
Survivors pension 100% £100 £188 n/a
RPI escalation £257 £229 £254
Escalation at 3% £278 £250 £278
Escalation at 5% £443 £396 £436

Annuity table – the annuity rate costs shown above are based on annuitant at the age of 65 and should be used as a guide only. For an annuity rate specific to your circumstances you should contact us.

For example, the cost to a female of adding a guaranteed period of 5 years will be £6, reducing her income from £1,000 per year to £994. For a male the cost would be £8, reducing his income from £1,000 per year to £992. This difference is due to the fact that male life expectancy or mortality is shorter than for a female and therefore represents a higher risk for claiming.

Also, for a female the cost of a 50% survivors pension is £77, reducing her income to £923 per year whereas for a male this is £140, reducing his income to £860. The difference is due to the fact that it is more likely a female will outlive her spouse and therefore the risk to the insurance company is higher where the annuitant is the male.

Also, for a female the cost of a 50% survivors pension is £77, reducing her income to £923 per year whereas for a male this is £140, reducing his income to £860. The difference is due to the fact that it is more likely a female will outlive her spouse and therefore the risk to the insurance company is higher where the annuitant is the male.

What is escalation?

This is a term for a pension which increases each year. The idea of this is to combat the effects of inflation and to maintain the buying power of your pension over the years. You can ask for your pension to increase in line with the Retail Price Index (RPI) each year, or it can increase at a fixed rate (3% or 5% each year are the most common). The problem with an increasing pension is that it drastically reduces your initial annuity in comparison with a level annuity. For a 3% increasing annuity, you would currently have to survive for at least 15 years before your increasing annuity had caught up with the income you would have received from a level pension.

How often will my pension be paid?

You can usually specify that your pension be paid monthly (the most popular), quarterly, half yearly or annually. The payments can be in advance (with the first payment coming immediately the annuity starts) or in arrears (monthly in arrears would start after 1 month). This has a small effect on the annuity rate offered, more so if the payments are less frequent.

What are ‘Protected Rights’?

This is a part of your pension fund which has built up as a result of payments from the DWP, usually because you have ‘contracted out’ of the earnings-related part of the State Pension, known as S2P or SERPS. Protected Rights have special rules attached which makes them slightly different from the rest of your pension fund. They have to be paid out using unisex annuity rates – in practice this means slightly worse rates for men (and better rates for women) than they get on their main pension fund. Protected Rights annuities have to include a 50% spouse’s pension if the annuitant is married. They can only have a maximum guaranteed period of 5 years. Other then this, the rules are the same when buying your annuity with normal or ‘Non-Protected Rights’ pension funds. Some enhanced annuity providers do not accept Protected Rights funds

What is an enhanced annuity?

Certain people can get a better annuity rate from specialist annuity providers based on their state of health. The logic is simple – if you are in less than perfect health then you are not likely to live as long so the company will offer a better annuity rate for you. You need to provide health details, and the annuity provider will underwrite you and offer an annuity rate. This can get you a rate that is 25% or more higher than the best standard annuity. These are becoming more and more popular, because even those with minor conditions like high blood pressure, obesity, or high cholesterol can get a better rate. The downside of this for healthy annuitants is that it will tend to drive down annuity rates for them. The reason for this is that unhealthy annuitants who take a standard annuity and then die early are currently subsidising the annuity rate for healthier individuals who live longer than average. If more of the unhealthier people are segregated into enhanced annuities then this subsidy will have a lesser effect, pushing down standard annuity rates.

Should I buy an Investment-linked Annuity?

Investment-linked annuities put your pension fund into investments, such as stocks and shares. This means you could continue to benefit from stockmarket investments after retirement, but there is also the risk that the value of your investments could fall.

Investment-linked annuities can either be:

  • with-profits – these link your income directly to the performance of the insurance company’s with-profits fund; or
  • unit-linked – these link your income to the funds you invest in.

There will usually be a choice of funds for you to choose from.
Investment annuities usually have higher charges than basic annuities so bear in mind that some of your fund will pay these and annual charges up-front and that this could also reduce your income in retirement. You should get specialist financial advice if you are considering an investment annuity.

What is Annuity protection lump sum death benefit ?

An annuity protection lump sum death benefit is another way of protecting your annuity if you die before age 75. A lump sum equivalent to the amount used to buy an annuity, less any income you have received, will be paid to your estate or beneficiaries on death.

There will be a tax charge, and depending on the amount of money within the estate after the payment is made, there could be an inheritance tax charge.

An annuity with a guarantee or an annuity with a lump sum death benefit will be more expensive than a conventional annuity, so the income you will get will be lower.

You can compare annuity rates for single or joint-life, level or escalating annuities at Compare annuities. Enter the type of annuity you’re interested in and the size of your pension fund and see what you could get.

Types of retirement options

After taking any lump sum, there are a number of ways to take an income from your money purchase pension. Some, such as an unsecured pension or phased retirement, may only be suitable if you have a large pension fund or other substantial assets and you are prepared to take some risks with your pension fund to get greater flexibility and a higher return.
Your options include:

  • a lifetime annuity;
  • an unsecured pension; and
  • phased retirement.

What if my pension funds are small (less than £17,500)?

If the total of all your pension funds is less than a minimum amount, you can take some or all of your pensions as a cash lump sum, rather than taking an income. This is known as trivial commutation.

You must be between at least 60 but not yet reached 75 and all the pension funds which you want to “commute” must be converted to cash within a 12-month period.

A quarter of the money you will get is tax free and the rest will be taxed as income.

You don”t have to “commute” all your pension funds, but bear in mind that it might be difficult to get a retirement income from small funds because many annuity providers will not take funds below a specified minimum, say £10,000.

What if I have more than one Pension fund?

If you are using more than one pension fund to buy an annuity, think about combining them when you are shopping around. You may get a better annuity rate from a larger fund. If you have small funds, combining them may also enable you to achieve total funds above the minimum specified by providers.