Here's the lowdown on annuities - a crucial part of how the pensions system works for many people.
In the first two parts of this series I explained the main types of pension. I did this so you can figure out what your current pension position is. But there's one final piece of the jigsaw that we need to look at - annuities.
Annuities is a crucial subject if you have a defined contribution pension. You can't figure out your current pension position if you aren't up to speed on this.
So here's the lowdown on annuities:
When it comes to defined contribution pensions, most people normally convert their pension pots into retirement income via an annuity.
Basically, you give your pension pot to an insurance company, and it then promises to pay you an income for life.
The rate you receive will depend on a number of factors including:
- Your age (the older you are, the bigger your income)
- Your health (the healthier you are, the smaller your income)
- Where you live (if you live in area where life expectancy is high, you’ll get a smaller annuity)
- The type of annuity that you buy.
You could buy a 'level annuity' where you receive, for example, £10,000 a year. That sum will never rise during your retirement. If you're worried about inflation, you could buy an 'index-linked annuity' where your income will rise as inflation goes up. However, your income will start at a lower level at the beginning of your retirement. You could also buy an annuity where the income rises by, say, 3% a year.
Similarly, you could buy an annuity that will also support your spouse after your death. Once again, if an annuity covers two people, it will start at a lower level than it would for just one person.
If you want to make sure you get the highest possible annuity, shop around. You don't have to buy an annuity from your pension provider, and the difference between the highest and lowest payers can be substantial, sometimes as much as 20%.
How big an annuity could you get?
Annuity rates have fallen dramatically over the last 20 years. That's largely because interest rates and inflation have fallen too. Rising life expectancy has also been a factor.
As I write, a single 65 year-old non-smoking male with a £100,000 pension pot could buy an annuity that would pay him £6,422 a year until he died. This example is a level annuity that is just for the man. If the man in this example was married, his wife would receive nothing after his death.
If you want to check the latest annuity rates, check out our annuity calculator.
Now, I know those last few paragraphs might have scared you. You might think that it'll be tough to build a pension pot as big as £100,000 while an income of £6,422 isn't that much. Well, in a later post, I'll look at how you might be able to save £100,000.
And £6,422 isn't as bad as you might think. If you added the current state pension (£4,953 a year) to your private pension, you'd have an annual income of £11,734. If you've paid off your mortgage by the time you retire, you wouldn't be on the poverty line on £11,700 a year - although I admit you'd be far from rich either.
Alternatives to annuities
If you've built up a pension pot via a defined contribution scheme, you no longer have to buy an annuity at any stage these days.
Instead you can choose to take an annual income from your pot while the rest of the pot continues to be invested. This is known as income drawdown. There are two types of drawdown: flexible drawdown and capped drawdown.
Capped drawdown
Capped drawdown is the safer option of the two as it doesn’t allow you to withdraw a sum from your fund that would be larger than what you would get from an annuity. You might think that Capped Drawdown is no different from an annuity, but there is one big difference. If you die while there is still money in your pension fund, that money can be passed to the beneficiaries of your estate subject to a 55% tax charge.
The government imposes a limit on the amount you can withdraw via Capped drawdown because it doesn’t want you to spend all the money in your fund before you die. If you spend all the money in your fund, there’s a good chance you’ll become 100% reliant on the state and the government doesn’t want that to happen.
Flexible drawdown
Flexible drawdown allows you to withdraw larger sums each year from your pension fund. But you need to demonstrate that you’ve already got a significant pension income to qualify. You need to show that you receive at least £20,000 a year from other pension income known as the Minimum Income Requirement (MIR). This income would be generated from things like:
- Lifetime annuities
- Pensions from a defined benefit scheme
- State Pension
The rules for flexible drawdown are quite complicated. You should only do this if you’re confident that you don’t want to make any further pension contributions.
The risks of income drawdown
Income drawdown is a riskier option than most annuities because your pension pot will probably remain invested in the stock market or bonds or both. So the value of your pension pot could rise while you’re retired and hence boost your retirement income, or it could fall. There's also the risk that you'll use up all your pension before you die.
Drawdown is also normally more expensive than an annuity.
Tax-free lump sum
When you get to the stage when you want to withdraw money from your pot, remember that you can withdraw up to 25% of your pot as a tax-free lump sum. You could use that money to travel or go on a cruise. You could start your retirement in style!
More: Become a pensions expert in five days - don't panic | How to buy the right annuity | When you're better off sick