Although annuity is one of those terms that has become part of everyday speech, it still holds an element of mystery. Essentially, an annuity is one way you can use your defined contribution pension pot to set up an income.
Thanks to pension freedoms, there are so many ways in which you can make your retirement pot work for you. Like all of your pension options, annuities can be complex to understand.
This article breaks down exactly what annuities are, how they work, and some of the pros and cons you should be aware of.
An annuity is a package provided by an insurance company. You can use some or all of your defined contribution retirement savings to buy an annuity, which will provide you with a guaranteed income. This offers a certain amount of peace of mind and financial security.
Think twice
Before you decide on an annuity you need to be aware of all the options available to you. For instance, from the age of 55 you can usually begin to withdraw money from your defined contribution pension however you like. This means you can draw down part of your fund either as a lump sum, many lump sums, or as an income, while the rest of your pot remains invested (flexi-access drawdown). With these options, the money you do not take continues to have the potential to grow. With an annuity, your savings are no longer invested. Instead, you receive a regular income for life.
It is important to remember that withdrawing money from your pension early will leave you worse off in retirement.
An annuity is a good option if you want a guaranteed income for life without the risk associated with investing your money. Knowing which option is best for you can depend on many different factors such as: age, health, level of risk you are prepared to take, etc. It is also important to consider that different annuity providers will offer different rates – you should always shop around before deciding.
Speaking with a regulated financial adviser can help to make sure you are making the right decision.
Having a guaranteed income for the rest of your life after you retire sounds very enticing. However, if you are looking 20 years into the future, it is impossible to determine the value of that income due to economic factors and price rises. Luckily, you can buy an inflation-proof annuity.
The amount you receive with an inflation-proof annuity will increase in line with inflation. But the downside of this kind of scheme is that your monthly income when you first access it is likely to be greatly reduced in order to keep up with future inflation rates.
An escalating annuity, as the name suggests, increases at a set rate. For instance, it will be agreed at the outset what percentage your income will increase by each year.
One of the most popular annuity options is a lifetime annuity. This means that your annuity provider will pay you a guaranteed income for the rest of your life. Although, you may find buying an annuity for a fixed term suits your circumstances better. This way, you can use part of your pension pot to buy a short-term annuity, leaving the rest of your fund invested to give it the potential to grow. You may decide later to take a lifetime annuity.
We all have different lifestyles which may need financing, or health issues which may warrant more financial input in the future. If you feel that either of these factors may necessitate an enhanced income as you get older, it may be a good idea to consider an enhanced annuity. An enhanced annuity pays a higher income to those who have health or lifestyle conditions that are likely to shorten their lifespan. For example, if you have a pre-existing health condition or if you smoke.
The great thing about a joint-life annuity is it looks after both people in a marriage or civil partnership. If you were to die, it will continue to pay a fixed income to your partner. But be aware that this facility will mean that the overall monthly income is likely to be reduced.
The main difference between an annuity and drawdown is the former offers you a fixed income for the rest of your life whereas the latter allows you to access your pension money at any time, as and when you need it. There are obvious risks and benefits here. Drawdown, for most people, is more flexible. It also allows you to keep the remainder of your pension savings invested. But with those benefits come risks. If you treat your pension pot like a bank account, you may find it falls short when you finally retire.
It is also important to consider that investments are liable to swings in value; the amount your pension is worth could drop dramatically if the investments do not perform well. This means that any income you may need is not guaranteed. You can never be certain whether your pension investments will grow. On the other hand, an annuity may be less flexible, but it offers a certain peace of mind when it comes to future income.
Before 2015, (when pension freedoms was introduced) annuities were highly popular, but now, in the 2020’s, it has been reported by the Financial Conduct Authority that drawdown sales are twice that of annuities.
Pros
Cons
The monthly income you receive will fundamentally depend upon how much money you have saved and the rates that the annuity company is offering. So, it is important to understand what different rates there are on the market. Don’t simply take the first option offered by your pension provider. A regulated financial adviser can be very useful at a time like this as they can explore various rates and different annuity structures, but also any other options available to you depending on your circumstances.
https://www.ageuk.org.uk/information-advice/money-legal/pensions/annuities/
https://www.joslinrhodes.co.uk/pension-advice/annuity-vs-drawdown/#4
We can help you to make the best possible decisions when it comes to your pension.
