FOOL SCHOOL
All About Annuities

December 13, 2004

One of the restrictions with personal pensions, and for that matter money purchase company pensions, is the requirement to use the bulk (generally 75%) of your accumulated pension fund to buy something called an annuity before you are 75 years old. You can take up to 25% as a tax-free lump sum when you retire.

What is an annuity?

An annuity gives you an income for life and they are sold by insurance companies. You give them your pension pot, let's assume that it amounts to £100,000, and they promise to pay you an income for life of, say, £7,000 per year.

The rate you get will depend on a number of factors. The younger you are, the less you'll get each year as the insurance company is likely to pay out for a greater length of time. If you're a woman you'll get less as you're expected to live longer. You can also get annuities that continue to pay until both you and your spouse dies. And you can also get annuities that increase in value each year so that you can keep up with inflation. Of course, in the last case you'll have to accept a lower starting amount.

On top of that, you can also shop around at different companies to see who is offering the best rate. 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%. In addition, if you smoke or have one of a range of medical conditions, you may also get a higher income by choosing what is known as an enhanced annuity.

All told, choosing an annuity can be a decidedly tricky business and you only have one shot at it. Once you've bought an annuity you can't then go back and change your mind if you find a better deal. One alternative you do have at the moment, if you have a large pension pot, is to delay buying an annuity and go for an option called income drawdown instead. However, under the current rules (which apply up until April 2006 as we explain below) you still need to buy an annuity with the remainder of your fund by the time you reach 75.

Annuity pros and cons

You've been saving in your pension fund all your life and, don't forget, the Government's been letting you do it before you pay tax. Now the Government wants its tax, and it gets it back because you have to pay tax on the income you get from your annuity.

The Government, in fact all of us really, also don't want to see you blow all your cash on the bingo and end up living off the state. So it makes you buy an annuity with most of your pension fund and the idea is that that should keep you off the streets. An annuity is also a means by which you can ensure than your pension fund runs out exactly when you do. It doesn't matter if your retirement lasts 50 weeks or 50 years it'll keep paying out. But when you die, that's it. There is nothing left for you to pass on to your descendents. That's what annuities do - they give certainty.

As always, though, there is a big price to pay for this certainty. In order to guarantee to pay you a particular amount for the rest of your days, the insurance company has to back up its promise to you with some very safe investments. In fact, your annuity is effectively backed by the safest investment of all - gilts.

Herein lies the main drawback. Gilts are all very well for a short amount of time but over long periods of time, they have not offered a great rate or return. Annuities made more sense when retirements lasted for only a few years, but now people are living longer and longer in retirement. Thirty years is certainly not unusual these days and it's getting longer still. Investing for these sorts of period is the province of 'real assets' like shares and property. After all, with the inflation we've seen over the last 30 odd years, an annuity from the 1970s would now be looking decidedly inadequate.

The future of annuities

Annuity rates are much lower than they have been in the past. In fact, they've roughly halved over the last 25 years. This has led to many people campaigning for the compulsory purchase of annuities to be removed and, to some extent, the government has listened.

From April 2006, new pension legislation will take effect. This will give you the option of taking an Alternative Secured Income instead, which may mean you'll be able to pass on any unused pension after your death. However, you will still have to take an annual income from your fund, which will then by taxed. The minimum amount will be £1 a year and the maximum will be linked to annuity rates. In addition, there will be two new types of annuity - the Limited Period Annuity and the Value Protected Annuity. The former lasts for just five years, after which time you can buy another one, or a normal lifetime annuity. The latter will pay out any unused amount to your heirs, but you'll get a lower income than a normal annuity.

> Find out more in our pension centre.