FOOL SCHOOL
Pensions: Annuities

June 17, 2002

The government -- and you won't be surprised to hear this -- doesn't trust you a great deal. It doesn't trust you not to blow the entire amount of your retirement fund on a rank outsider in the 3.30 at Kempton Park or a two-week orgy of high living in a pink Rolls-Royce with personalised number plate 'FOOL 1'.

If they did trust you not to do any of these things and you let them down, then they would end up having to feed and house you and that's why they make you buy an annuity with the money you have accrued in your PPP or AVC fund. It's a very sensible decision on their part, they see it as just return for their generosity in giving you tax relief on your pension contributions for all those years, and it lets them avoid what could potentially be a whole lot of bother. For you, though, it may not be so good. Let's see why.

Annuities

An annuity is the way in which you convert the money you have built up into a regular income to see you through your retirement. It works broadly like this:

1. You retire.
2. You take the dosh in your PPP, AVC or Defined Contributions occupational pension fund and use it to purchase an annuity, either from the company with which you already have your policy, or another company (for the privilege of which you may be charged a penalty by your original company).
3. The annuity pays you a fixed income until you die. The precise amount depends on how long they think you have left to live. Women, who live longer than men, receive less than men of the same age. Older people receive more than younger people. Students of the macabre will note that with some companies, fat smokers can negotiate larger payments than slim non-smokers (impaired life annuity).
4. The amount you receive does not increase with inflation, unless you have agreed to accept a substantially reduced initial annuity income.
5. Your spouse may get nothing when you die, unless, again, you have agreed to accept a substantially reduced initial annuity income.
6. Finally, you and your spouse both die. BIFF! When you and your spouse are both dead, the annuity company keeps the money. Your relatives or favourite charity get nothing.

One of the problems with annuities is that these days we are living too long for them, and the rate of inflation is just that little bit too high to make them last. With the basic annuity, an insurance company effectively takes your money and uses it to buy some gilts. It buys gilts because it needs something that is considered to be low risk and that provides an income. But people reading this may be looking at twenty, thirty or even more years of retirement. And gilts tend to be an awful investment over that sort of period.

However, if you've built up a big enough pension pot, then at least you can buy the security of an inflation-proofed income and you can choose various ways of doing that such as buying a With Profits annuity or a guaranteed period annuity etc. You can find out more about them at the Annuity Bureau here. However, be aware that some changes are planned to what sort of annuities you can buy with your pension and the government began a consultation process on this in February 2002. 

Income Drawdown

An alternative option on retirement -- at least until you reach the age of 75 -- is to use what's known as income drawdown, or income withdrawal. The concept was introduced in 1995 and if your pension scheme permits it, it enables income to be paid to you directly from the fund, rather than by purchasing an annuity. The amount you can take out each year is subject to a maximum based upon annuity rates provided by the Government Actuary's Department. The minimum amount of income that must be withdrawn each year is 35% of the maximum. These limits are calculated when you retire and are reviewed every three years.

The advantage of income drawdown is that you're able to take the income you require (subject to the limits) while ensuring that your fund continues to grow. When you reach 75, however, you have to buy the annuity.

If you die while you are using the income drawdown method, then some or all of your pension fund can be passed on to a nominated beneficiary such as a spouse. There are two options. In the case of a spouse or dependant, the whole fund can be used to provide an income, by buying an annuity or under income withdrawal. Alternatively, the spouse, dependant or beneficiary gets the full cash value of the fund minus 35% which goes to the Government (it's a way of them getting their tax relief back).

If you die before you retire -- the whole fund can be passed to a spouse, dependant or other beneficiary. However, this is only in the case of a strict personal pension. If the fund includes any transfer values from an occupational scheme, the rules will be different.

More: The Fool's Pension Centre