Annuities

What is an Annuity?

To ensure a pension pot flexibly lasts for the duration of any given retirement period, the best option is usually to hold it in a form that will provide a regular income, ideally without depleting the pot’s base value. While building up a pension pot, returns earned from assets the cash has been invested in are ploughed back into the pension in the form of compounded returns. Over a longer period of time, all or a large portion of a working lifetime, this has a very powerful impact on building up the pot’s final value.

However, once retirement age has been reached and a pension comes into active use, the returns generated by the pot’s investments are what provides a steady income for the retiree(s). While paying off and outstanding debts, if they exist, or investing in things such home improvements are not necessarily a bad way to spend a portion of a pension pot, it is also important that the capital which remains is sufficient to provide enough income for the holders to live comfortably from.

Buying an annuity with all or a part of a pension pot is one of the options available to pensioners when it comes to securing this regular income stream. An annuity is an insurance product which is bought for a one-off lump sum. The annuity holder then receives a regular annual income from the annuity provider. Depending upon the choice of the annuity product purchased, this regular income is usually fixed, though can also be variable and will either be for life or for a fixed maximum period of time.

Annuity Rates

The value of the annual income that an annuity provides is referred to as the ‘annuity rate’. The rate offered will depend firstly on the size of the lump sum you are able or wish to commit to buying the annuity. As a general rule, the more expensive the annuity the higher the annuity rate will be.

Because an annuity is an insurance product, the rate will also vary in accordance with the provider’s assessment of your likely life expectancy. This is done in a similar way to if you were purchasing health insurance.

The insurer will assess your current health, any past or current health conditions, your lifestyle (eg. are you a smoker, do you take regular exercise?) and family health history. The difference between health insurance and an annuity is that while the worse your health is considered to be the more you will be charged for health insurance, the better your health is the more you will be charged for an annuity! This is for the simple reason that the longer you live the longer the annuity provider will be obliged to pay you your annuity rate.

Delaying an Annuity Purchase

The cut off age for buying an annuity used to be 75 but there is no longer any upper age limit. As a result, some pensioners who intend to eventually invest in an annuity defer doing so until later in their retirement. This could be for numerous reasons such as expecting that annuity rates on offer will improve in the future.

Annuity rates are influenced by interest rates and higher interest rates have historically meant more attractive annuity rates. This is because the annuity provider may well invest part of your lump sum in debt such as corporate and government bonds.

Spending Activity

Another reason why an annuity purchase might be delayed is because an individual wishes to stage the flow of their spending level over different periods of their anticipated retirement trajectory. A typical pattern of retirement is that over the first several years pensioners are most active. While health and energy levels are good retirees often wish to travel, make home improvement and spend time on hobbies and other activities they didn’t have the same opportunity to enjoy while working full-time. During this first stage of retirement, finances allowing, retirees may actually have higher expenditure than while working.

During the second stage of retirement pensioners would typically expect to have settled into more of a domestic routine and live a little more slowly. Hopefully their health will still be reasonably good and an active lifestyle can still be enjoyed but the most common pattern would be that a slowly changing lifestyle will lead to lower expenditure. As a pensioner ages and health may start to become more fragile and energy levels drop, the amount spent would also be expected to naturally taper.

Later Purchase

Delaying the purchase of annuity to perhaps the ‘second’ phase of retirement is one way to strategically manage the cash flow provided by a pension pot. A later annuity purchase is one way to ensure a pension both last for as long as it is needed while providing greater spending flexibility in the first years of retirement.

However, there are also annuity products that can be purchased earlier but still offer the option for payments to be delayed for a fixed period of time or until the holder wishes to start receiving them.

Annuity Options

There are quite a number of different kinds of annuity available on the UK market, each best fitted to a different set of financial considerations or personal circumstances. A delayed annuity is just one such option. While this is not an exhaustive list and various hybrids and variations on these main categories are available, most annuity products fall into the following categories:

Annuity Advantages

As with any product, annuities have their strengths and weaknesses in comparison with other options available to pension holders who wish to secure a regular income from their pot.

Annuity Disadvantages

When Might an Annuity be the Right Pension Choice?

Purchasing an annuity with all or part of a pension pot is a decision that should be made based on personal circumstances and evaluation of what the prospective holder’s needs will be during retirement. An annuity de-risks retirement income but at a price. One major consideration is if a pension pot is large enough to buy an annuity that will provide a rate sufficient to live from during retirement. A careful decision should be made as to whether the security an annuity provides compensates for a reduced income that is not at risk to external financial market factors.

Delaying an annuity purchase or splitting a pension pot between the security of an annuity and more lucrative risk-based investments is also an option. Anyone who does not feel confident in being able to fully assess the pluses and minuses of the different income producing pension product options available to them should consult with a certified financial advisor.