Wow! That was one wild party, my retirement bash. I had everyone back to my house afterwards as well - I really should have known better! I remember coming out of the loo and trying to get downstairs only to find Gerald (who is a semi-retired electrician) passed out on the stair lift. Even worse, he had rewired it so that it didn't stop at the top or bottom, but instead carried on in its tireless traversal of the stairwell all evening! But I think the thing everyone will recall from that night, other than Hillary falling into the walk-in bath, was the revelation that I was retiring but hadn't yet purchased my annuity. The next couple of weeks were pretty stressful I can tell you; if only I had read this - things would have been so different...
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The importance of doing your homework before purchasing an annuity can't be understated. If you get it wrong, they can be difficult or nigh on impossible to change later on. Therefore it is really important to make a fully considered choice to ensure you enjoy the best income possible into your old age.
What is an annuity?
You will usually buy an annuity when you retire (although this isn't compulsory, there are other options available), if you have saved into a defined contribution or money purchase pension scheme to help replace some of the salary that you no longer receive. An annuity provides you with a guaranteed income for the rest of your life and is usually purchased by a portion or the full amount of a pension pot. The annuity income is then paid to you (usually monthly) and is subject to income tax in the same way your wages are.
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[If you are one of those lucky blighters who have a defined benefit or final salary pension read no more, you will not need to set up an annuity as your employer's scheme will provide you with an income - if you are unsure whether you are on a defined benefit or final salary pension scheme you should contact your pension provider.]
As I'm sure you can imagine, there a lot of things to think about when purchasing your annuity:
- When you are approaching the point of retirement, your pension provider will normally offer you a quote for an annuity from them. However, you have the legal right to shop around (called the "open market option"); make sure you do- as with all financial products you will often find considerable variance between what different providers will offer. Your pension provider will send you a letter with the value of your fund prior to your retirement date - you should use this figure to compare annuity quotes with.
- Having said that you should always shop around, you should certainly not discount what your existing provider is offering you. Some pensions, particularly older ones, offer a Guaranteed Annuity Rate (GAR). A GAR (as well as being the onomatopoeic term for the mating call given by the Lesser Bearded Kestrel) may be quite a bit higher than those available on the open market, particularly given that the average income that annuities offer has dropped substantially over the last few years.
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- Age. You can purchase an annuity from the age of 55; however, there is no requirement for you to actually retire when you start to receive your pension. Generally speaking, the younger you purchase your annuity, the less of an income it will pay as the provider assumes that they will have to pay for a longer period.
- Single or Joint? When you come to purchase an annuity you can normally set up the income to be paid for as long as you live (single); or, if you die before your partner, as long as they live (joint). It is worth noting that whilst a joint annuity will pay less than a single annuity (as with younger age, a provider will expect to be paying a joint annuity for longer) your spouse/partner would not lose the income from the annuity in the event that they outlive you. There is a third option also: to have a joint annuity where the income continues paying a reduced rate after the first death. This can strike a balance between making sure your loved ones still have an income (albeit reduced) when you go, but also giving a slightly higher annuity rate in comparison to a standard joint annuity.
- Guarantee period. Another option to consider is whether to have the payment of your annuity guaranteed for a certain period. This, rather confuddlingly, is different to the Guaranteed Annuity Rate! A guarantee period instead refers to a minimum period over which the annuity will be paid (typically 5 or 10 years) even if you die during this time. Of course once you survive this initial guarantee term (phew- close call!) you will continue to receive your annuity, although your estate will not continue to receive your annuity if you pass away after this point.
- Level/Escalating annuities. You can choose an annuity to pay either a level income throughout the life of the annuity, or an escalating income which can either increase in a set increment (for example by 5% per year) or in line with inflation. You should note that level annuities will pay a significantly higher amount in the early years (although the real value of the income might erode with inflation), whereas escalating annuities pay more the older you get. Although you might not consider inflation much of a factor at the moment, this can make a considerable difference over the long term to your income. You can also opt for a mixture of a level and escalating annuities, so consider all options carefully before making any decisions. Investment-linked annuities could also be an option if you are looking to mitigate the effect of inflation on your income. However, as with any investment there are risks, so make sure you get some independent financial advice if you are considering taking this route.
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- When you take your pension, you are able to take a portion of it (up to 25%) as a tax-free lump sum (this is also called a Pension Commencement Lump Sum for those of you who like a technical term!). Bear in mind that any cash you take from your pension will reduce the amount of income you will get when purchasing your annuity. If you are in any doubt over whether to withdraw some of this cash you should seek professional advice.
- Another little-known point worth mentioning here is the fantastically named Trivial Commutation. No this isn't a now long forgotten board-game where players have to answer questions to get to work on time; instead it refers to a rule that will allow you to take your whole pension pot as a lump sum, providing it is below a certain minimum threshold (currently 1% of your standard lifetime allowance or £18,000 to you and me). There is something to be aware of here: only the first 25% is tax-free, the remainder will be subject to income tax.
So, what factors influence how much income my annuity pays?
Some, although by no means all, annuity providers base the amount they will pay on certain factors. These include:
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- Your health. If you have or have had health problems in the past you might be eligible for an Enhanced Life Annuity. These normally pay more than standard annuities on the assumption (sorry, but this is why) that it won't be paid as long. Looking at it another way, this can also be a reason not to annuitise too early if you can avoid it - if your health deteriorates later in life and you have already purchased a standard annuity, you will not be able to change to an Enhanced Annuity
- Your lifestyle. We all know that things like smoking or being overweight isn't good for us. So too do those caring annuity people. Some will even offer you better rates. Gerald for instance has a wooden leg, weighs 30 stone and smokes 80 a day. He got such a good rate from his annuity he has had a cupboard carved out his leg (the wooden one) which he now keeps a bottle of Bourbon in.
- Your Occupation. Some occupations can have adverse effects on your health or even lifespan (For example, retired Emu farmers tend to die younger than their non-Emu-farming counterparts. Apparently this is due to a pheromone secreted by the female Emu which is particularly toxic if you are exposed to it over a number of years).
- Your...er...postcode! Some even decide how much you pay dependent on your postcode as average mortality rates differ widely between areas, sometimes even with large local variations. You will get particularly good rates if you live in the village of Midsomer - as John Nettles will tell you - although Life Insurance costs him a small fortune...
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So, there it is: the merry world of annuities. There isn't another single financial product out there that forces you to consider your mortality in quite the same way as an annuity. You not only have to think about the fact that one day you will not be here, but also consider how long you might have left! That's why it's important to make a considered choice when choosing the best annuity for you. Happily though, once you have your annuity set up, you can concentrate on living as long as possible and trying to squeeze as much annuity out of your provider as you can!
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