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What is an Annuity and how do they work?

As you approach the end of your working life a big concern will be how much retirement income you will receive and how this will impact your standard of living.

As employers have moved away from guaranteed pensions and more people have become self-employed most pension plans are now classified as defined contribution plans, with these plans the amount invested plus any growth is the amount of pension fund you will have available to you at retirement.

With this in mind and to remove investment risk you may wish to use your pension pot to buy a pension annuity. This will provide you with a regular income the rest of your life or for a specified period of time. The thought of this guaranteed income may give your retirement plans the security which you need.

What types of Annuity are available?

Life Time Annuity – Will provide you with a guaranteed income for the rest of your life. You exchange a lump sum (usually your pension savings) for this regular retirement income. The payments continue until you pass away. With this type of annuity you may choose for the income to be payable to your spouse or partner should you pass away.

Fixed-Term Annuity – Will provide a guaranteed level of income for a set period of time. Generally this will be for five to ten years but they can be for as long as twenty five years.

Joint Life Annuities – These types of annuities will continue to pay a regular income to your spouse or partner after your death, normally this will be a reduced rate.

Can my income increase in the future if I buy an Annuity?

There are several options when using your pension pot to buy an annuity and the level of income you will receive:

Level Annuities – Will pay the same income each year. Will start with a higher initial income than other types. But, they will not adjust for inflation. This means the real value of the income may decrease over time due to rising prices.

Escalating Annuities – These increase each year at a fixed rate, for example 3% per year. Often these will start with a lower initial income, but they can provide some protection against inflation.

Inflation-Linked Annuities – These will rise in line with the retail price index, this ensures your income will keep pace with inflation. However, they will generally provide a lower payment at the outset.

Impaired or Enhanced Annuities – If you have health conditions or certain lifestyle factors(such as smoking or being overweight) an enhanced annuity will pay a higher level of income. Providers will assess your income based on your health.

Is income from an Annuity taxable?

Any income which you receive from an annuity will be taxable. However, this will depend on the overall level of income you receive in the tax year. Your personal allowance will allow you to earn £12,570 per year without paying income tax. Your state pension will count towards this allowance.

Can I still take tax free cash if I purchase an Annuity?

You can choose to still take 25% of your pension as a tax free lump sum at outset if you decide to purchase an annuity. This will reduce the amount of funds you have available to purchase your annuity, meaning a lower income for you in retirement.

How do I choose the right Annuity?

When deciding if you should buy an annuity you will need to consider your health, your required income and if this is short-term or lifetime and if you wish to leave an income for your partner/spouse if you were to pass away. You may wish to ensure that your standard of living will not drop in retirement as well as looking to takeaway investment risk from your retirement plans.

You should shop around for the best annuity rates and features as providers offer varying terms and options. Using your pension pot to buy an annuity is a big decision and seeking professional advice will ensure you make an informed choice based on your personal circumstances.

Here at PAB Wealth Management we can search the market for you to ensure you get the best deal whilst you will have the peace of mind of knowing you are dealing with a Financial Conduct Authority registered financial adviser.

Book a free 30-min consultation

Luke Thompson

Financial Adviser