TPAS - The Pensions Advisory Service

Annuities

A member of a money purchase arrangement (i.e. an occupational money purchase scheme, a personal pension plan or a stakeholder pension scheme) builds up a 'pot of money'. On retirement, the member usually has to use all or part of the pot to buy an annuity.

An annuity is a contract between an insurance company and a pension scheme member under which the member hands over all or part of their pension fund to the insurance company which agrees to pay out an income to the scheme member for the remainder of that person's life. The annuity would normally be paid monthly, quarterly, half-yearly or annually.

The amount of the annuity may stay the same throughout the years of payment or may have automatic annual increases built in. These increases may be at a fixed rate, e.g. 3% per year, or the rate of increase may vary, e.g. with the annual change in the Retail Price Index.

The annuity can be set up so that all or part of it reverts to your spouse or partner in the event of your death. Also they can be set up so that they are payable for a minimum period, say 5 or 10 years, even if you die before that period ends.

The value of the annuity is dependent on two factors – the size of the pot and the annuity rate offered by the insurance company selling the annuity. The annuity rate is basically the factor used to convert the accumulated fund into pension. For example:

Value of fund x Annuity rate = Annuity

Annuity rates are calculated by actuaries using various factors – mortality, interest rates, age, gender and sometimes health. In general terms, annuity rates are higher the older a person is because future life expectancy is less. In the same way men get higher annuity rates than women of the same age due to men having lower-life expectancy.

In addition, enhanced annuities are available to those who have a shortened life expectancy due to poor health. These are known as impaired life annuities.

The FSA have produced a guide to Annuities and Income Withdrawal which can be downloaded from their web-site, www.moneymadeclear.fsa.gov.uk.

Q & As

How can I compare annuities?

It is important to note that the pension provider that has been investing a member's fund is not always the one offering the best annuity rates. Members should consider taking advantage of the Open Market Option (OMO). This involves searching the market place for the best possible annuity. An Independent Financial Adviser (IFA) may be able to assist a member in doing this. TPAS is not authorised to give financial advice. Anyone seeking financial advice should contact an IFA. The following organisation will be able to provide an individual with a list of IFAs in their local area.

IFA Promotions
17-19 Emery Road
Brislington
Bristol
BS4 5PS
Telephone: 0800 085 3250
Website: www.unbiased.co.uk

The following links are to the websites of various organisations that show annuity rate comparative tables:

• Financial Services Authority at www.moneymadeclear.fsa.gov.uk
• Money Facts at www.moneyfacts.co.uk

Can I switch to any insurance company?

This is not always possible as not all insurance companies provide annuities. Some companies may refuse to offer annuities based on certain types of funds such as Protected Rights. Others may have minimum fund value and refuse to accept your fund if they deem it to be too small. This will restrict your options to switch to a different annuity provider.

Should I always switch?

If the rate offered by a competitor is only marginally better than the existing rate you may consider that it is not worthwhile to transfer. You should also take into account any Guaranteed Annuity Rate (GAR) that may be offered by the existing scheme as this 'guarantee' is usually valuable and will be lost on transfer. If you are taking your benefits before or after the selected retirement date, you may find transfer value is subject to a penalty charge.

What is a GAR?

A GAR, guaranteed annuity rate, is a fixed rate, written into your pension contract, at which you can convert your fund into an annuity, irrespective of what open market rates are doing at that time. There are normally some conditions written into the application of the GAR. It is usually only available at the scheme's Selected Retirement Age i.e. it will not apply if you retire early or if you retire late. It normally will only provide an annuity on your own life and often will not provide for post retirement increases.

The attraction and value of the GAR is that it can produce a pension for life that is higher than anything you can get by applying your fund to buy an annuity from any other insurance company at the time you retire.

The downside is the restrictions which may apply and highlighted above, e.g. based on your own life only, etc.

What factors make annuity rates worse?

Having an increase on the pension, having the pension set up so it is payable to a spouse if you die, having a guarantee period or retiring early, all result in a lower annual annuity. In general the more options you want, then the more expensive this will make the annuity and therefore the starting level of the annuity will be lower.

What factors improve the level of annuity rates?

Not having an increase to the pension, having a short guarantee period or none at all, not having a spouse's pension or retiring later will all improve annuity rates. However, if you retire later, there may be penalties so you should check this out with your provider.

What is a guarantee period?

If your pension is guaranteed for a period of say 5 or 10 years this means that should you die within that time the pension will continue to be paid until the guarantee period ends. The payments can continue to be made to your spouse or someone who is financially dependent on you. Otherwise payments will be made to your estate and distributed according to your will. Provided you die before age 75 and the original guaranteed period was 5 years, it is possible for the remaining pension to be paid as a lump sum to your beneficiaries but it will be subject to a special tax charge, currently 35%.

What options should I choose?

You should always choose options that most suit your own circumstances, for example, if you are not married or do not have a partner, there is little point in having a spouse's pension. Once the annuity is set up you cannot change it.

What is a Capital Protected Annuity?

This is a new type of annuity under which, if you die before age 75, a lump sum is payable to your beneficiaries or your estate. The lump sum is the amount you paid to buy the annuity less the total already paid out to you in annuity payments. There will be a tax charge, currently 35% of the lump sum payable.

Do I have to have an Annuity?

If you are a member of a defined benefit scheme, you must begin to draw your pension on or before age 75. If you are a member of a money purchase scheme, a personal pension plan or a stakeholder scheme, a life time annuity must be secured on or before age 75.

The only alternative to this is to put your funds into an Alternatively Secured Pension (ASP) the working which is described in the next question.

What is an Alternatively Secured Pension (ASP)?

An ASP is an arrangement that can be used at age 75 to avoid buying an annuity if you believe this does not suit your needs or if you believe that better annuity terms may be available at a later date or you want to keep your pension fund invested under your control. How an ASP works is that all your pension monies, not invested in annuities, make up your ASP fund at age 75. Any capital growth or income arising from those assets are treated as part of the ASP fund. An income can then be drawn from the ASP fund and the member is free to vary the amount paid year-by-year within the specified limits. The minimum amount of annuity is nil and the maximum is 70% of the amount that could have been bought at age 75. This rate is laid down in tables produced by the Government Actuaries Department (GAD). The maximum amount must be recalculated each year at the beginning of the pension year. The first pension year runs from your 75 th birthday. The recalculation is made by reference to the then current GAD tables for someone aged 75. Each year as you get older the maximum continues to be assessed as if you were still 75. You can stop your ASP at any time and apply your fund to buy an annuity.

Who should qualify as a dependant?

A dependant is the spouse at the date of death, a child of the member provided the child has not reached age 23 or, if 23 or over, is in the opinion of the administrator, dependent due to disability. Someone not married or is not a child of the member, may qualify if in the opinion of the administrator, he/she is financially dependent.

What is a temporary or short-term annuity?

It is an arrangement made between you and an insurance company of your choice under which you pay over part of your fund and in return the insurance company pays you an income for a fixed period of no more than 5 years. The payments must cease before your 75 th birthday.

The maximum amount that can be paid is calculated by taking a rate from tables drawn up by the Government Actuaries Department and applying to that part of your fund that is not invested in life annuities.

This maximum amount must be recalculated every five years. The annuity can be level or it can be arranged to increase each year at a fixed rate or in line with the Retail Price Index.

This type of annuity may be attractive to someone who wishes to defer buying a lifetime annuity.

When would I use a short-term annuity?

Short-term annuities are intended for those people who do not want to commit their pension funds to a life-annuity because they believe the rates may get better in the future. By using a short-term annuity, the decision on buying a life-annuity can be deferred. The decision cannot be deferred beyond age 75. Only part of your fund would be used in this way. The balance would be applied to an Income withdrawal arrangement which is explained later.

Can I provide an annuity for my Partner?

Yes but only in the event of your death. You can apply your fund so that all or part of your pension continues to be paid to your partner. A partner is someone to whom you are married (this includes civil partnerships) or someone who, in the opinion of the administrator, is financially dependant on you at the date of your death.

I have heard that if I buy an annuity, the Insurance Company pockets the rest of my pension when I die and my wife will get nothing. Is this true?

The basic rule is that an annuity is payable to you, the annuitant, for life. So, naturally when you die the annuity stops.

However, you should be offered some choices to provide money for your wife after you die. In most cases, you will be able to choose a pension that is guaranteed to be paid for a certain period, usually five or ten years, no matter what happens to you.

So, if you die, say four years after first drawing your annuity, if you have opted for a five-year guarantee, the remaining 12 months' payments will be paid to your wife or your estate. If you opt for the five-year guarantee, but live for fifteen years after retirement, your annuity will be paid to you for the whole of that period but nothing more will be paid when you die.

You might also have the option to use your pension pot to provide an annuity to your wife after you die. The pension available in this way is usually at half the rate of your annuity. This option will, however, reduce the annuity you will get.