Fact Files

Retirement is the time to use funds accumulated over the years to buy an income for life. There are a number of ways of achieving this, and the most popular is to buy an annuity.

This Fact Sheet looks at Annuities – what they are and how to get the best deal.

 What is an Annuity?

Annuity is the term generally used to mean the income that it bought in retirement with lump sum savings. The fund can come from personal savings, but is more likely to come from savings made into a personal pension.

Whichever way the money has been saved, there are choices to be made at retirement to make sure the best use is made of the funds. There is no one right choice – buying a pension is a highly individual matter with many variations and options.

We cannot stress strongly enough the value of good independent advice at this stage. Simply accepting what’s offered by the company you’ve been saving with can be a costly mistake.

Consider Mrs A – At 60, she wanted to reduce her work hours. She had a personal pension and came to us to check whether the offer from her provider was reasonable. We established she was taking medication to control blood pressure and were able to get her a much higher income. That meant more money every year for the rest of her life.


Even if you are unlikely to benefit from an enhanced annuity, it is still very important to shop around to get the best annuity rates, as there can be a nig difference between the best and worst providers.

Options

Buying an annuity can be a bit like buying a new washing machine – you pay for extra features, and like the washing machine you need to know what you’re getting for your money, and weigh up whether you actually need them.

Whether or not to take a cash lump sum is an important decision. It is usually possible to take a quarter of the fund as a cash lump sum, which is tax free, and the balance then used to buy an income. But not everyone needs a cash lump sum and for some people getting higher income for life is a greater priority. If you’re planning on investing the cash lump sum as income, you’ll need to consider what sort of investment returns you’ll achieve – and whether they will be as favourable as annuity rates/.

There are other key decisions to make to - like whether the income will increase, whether a spouses pension should be added, and the frequency and timing of payments. Once an annuity is started these things cannot be changed – so it is important to consider them carefully at the beginning. A financial adviser can talk you through the differences and help you decide what’s important to you – and what’s not.

Let’s look at the effect of inflation on a pension through retirement

Take a 65 year old man who has the option of a non-increasing pension of £8,000pa. If inflation is 3%pa his income will effectively reduce to £4,400pa by the time he is 85. But on the other hand the fund that could buy a pension of £8000pa now without increases is only going to buy about £6000pa if annual increases of 3% are built in.

The pink line on the chart shows how the real value of the £8000pa starting income falls over time (assuming inflation of 3%pa) compared with the annuity that starts at £6000pa and increases at 3%pa.

How annuity progresses with age

The decision on choosing a level or increasing annuity is not straightforward and will be made by balancing a desire for higher income in the early years with potentially less in later years.

Tax

There are valuable tax benefits to saving in a pension, which means that at retirement there are restrictions on how the money can be taken. Normally 25% of the fund can be taken as a tax-free cash lump sum, but the balance must be used to buy an income for life. This income is taxable at the person’s normal rate, and tax is deducted by the annuity provider in the same way that an employer deducts tax.

Other Options

The conventional annuity described in this page is not the only option available – there are other ways to take income, including With Profit annuities, Variable and Guaranteed annuities, and Income Drawdown.