If you’re nearing, or thinking about retirement, you may have started to think about how you want to access your pension funds. And what sort of income you need to fund your lifestyle goals in retirement.
One option you may have heard about is an annuity. But what exactly is an annuity, and how does it work?
What is an annuity?
An annuity provides a regular income, typically for the rest of your life, in exchange for a lump sum payment, taken from your pension pot.
You purchase an annuity from a provider, (who isn’t always your pension provider) who will then pay you a regular income in return.
How do I buy an annuity?
First off - shop around. The income you can get each month or year will depend on the size of your pension pot and which provider you choose and there could be quite a difference from one to another.
Different providers use different rates to calculate the income they’ll give you. They can depend on factors like interest rates as well as where you live, how old you are and if you have any underlying health conditions.
Types of Annuities
There are a few different types of annuities. Some of them may or may not be right for you. It’s a good idea to understand your retirement goals, and any tax implications, before you take one out. Here are the main types of annuities:
1. Lifetime Annuity
When you use some or all of your pension to purchase a lifetime annuity, you exchange a lump sum for a regular income that’s guaranteed not to run out before you die. You’ll agree the amount you’ll receive as income when you take out your policy with your provider, so you’ll always be clear on how much you’ll receive.
2.Fixed-term annuity
A fixed term annuity will still pay you a regular income, but only for a set period of time. You can usually choose the term from between one and 40 years. With a fixed-term annuity, your provider will invest the money you pay, and when the term ends, they’ll pay you a maturity amount. This is a lump sum of the money you paid, plus investment growth, minus any income you’ve already received. When your term ends, you can choose what to do with your maturity amount. You could use it to buy another annuity, or you could flexibly access it with drawdown.
3. Deferred annuity
Unlike a lifetime or fixed-term annuity, a deferred annuity won't pay you an income straight away and you choose when you want the payments to start, usually after a year or more.
Similarly to a fixed-term annuity, your provider will invest your money. How much you’ll get depends on your age and how much money you’ve paid to your provider.
4. Enhanced Annuity
An enhanced annuity can provide you with a higher retirement income, if you have a health problem that could reduce your life expectancy.
There are several common health problems, such as; stroke, cancer, heart attack and diabetes, that mean you may be able to get a higher pension income.
You may also be able to get a higher annuity rate if you work certain jobs that could impact your health.
You may have to provide your doctors information to the provider, as well as potentially attending a medical examination before the provider offers you an enhanced rate.
Other options when it comes to choosing an annuity
Buying an annuity is a bit like buying a new car. Once you decide the make and model (provider and type of annuity), you can then decide if you want some of the optional extras.
For example, you might decide to take out an annuity of a fixed amount, or an amount that increases each year, either with a set percentage or in line with inflation. You could also opt for an annuity that will pay a percentage to your spouse or civil partner if you outlive your annuity.
When it comes to understanding what’s right for you, it’s important to have a look at your own goals, and how you might need to use your pension income before making any decisions.
How to Find the Best Annuity Rate
Finding the best annuity rate involves shopping around and comparing offers from different providers. You also don’t have to get your annuity from your pension provider. Here are some tips to help you get the best deal:
1. Compare quotes: Use comparison websites to get quotes from multiple providers. This will give you an idea of the rates available, and any fees associated with your annuity.
2. Consider your health: Some providers offer enhanced annuities for people with certain health conditions or lifestyle factors that might reduce life expectancy. These can provide higher income.
3. Check fees and charges: Be aware of any fees or charges associated with the annuity. These can affect the overall value of your income.
4. Understand your options: It can be overwhelming trying to choose the best options for you. It can be useful to seek independent financial advice if you’re not sure what’s best for you.
Answering common questions about annuities
1. How are annuities taxed?
When you withdraw money from your pension to buy an annuity, the first 25% will be tax-free. When you are paid money from the annuity itself, it’s taxed as income. This will be at your marginal rate of tax and will take into account your total income including income from any other pension pots and the State Pension. You might find that this will push you into a higher tax band.
2. How are annuity rates calculated?
The rate you receive from an annuity provider will depend on the type of annuity you buy, and other personal factors like your health, your age, or even your postcode. They can also be impacted by interest rates and the wider economy. It’s good to shop around to find the best rate for you.
3. Can I change my annuity once I've bought it?
Generally, no. Once you purchase an annuity, you can't change the terms or access your lump sum. You’ll need to be certain that the income you’ve chosen with your annuity will be able to support you for the rest of your life.
4. What happens to my annuity when I die?
This depends on the type of annuity you have. Some annuities offer a spouse's pension or a guaranteed period, meaning payments continue to your spouse or beneficiaries for a certain time.
5. Are there any risks with annuities?
There are a couple of risks when it comes to annuities. The first is whether you live as long as you think you will. Which is a difficult thing to predict. You’ll also potentially be impacted by inflation. If you have a fixed annuity, your income won't increase with inflation, which could reduce your purchasing power over time. You’ll need to make sure you’ve considered rising costs, and any potential impact they could have on your income. As a general rule, you can’t predict what will happen to inflation in the future. But you can look at the trajectory of rising costs in the past, to give you an idea of how prices could change in the future.
Your pension is designed for later life. When you save into a pension, the value of your investment could fall as well as rise and you could get back less money than you put in. You usually can’t access your pension until age 55 (rising to 57 from 6 April 2028). Tax rules can change and depend on your personal circumstances.
With a Virgin Money Pension you can take your pension savings as one lump sum, with 25% of it tax free. To access your pension another way you'll need to transfer your pension to another provider. We won't charge you to do that.
This article can give you helpful tips, but it isn’t financial, or tax advice. If you’re not sure if something is right for you, you should speak to an Independent Financial Advisor.