Changes to the rules announced in the 2014 Budget mean that, from this April, you’ll no longer have to use the bulk of your pension pot to buy an annuity when you retire.
Instead, you’ll be able to treat your pension more or less like a bank account and, within certain constraints, make withdrawals from it whenever you need, or indeed, want to.
But does this mean annuities will become redundant? We look at whether they could still have a place in your plans for the future.
What exactly is an annuity?
An annuity provides you with a guaranteed income for life in return for a lump sum payment.
You hand over a chunk of your pension savings to an insurance company, which then pays you an income until you die (or until your surviving spouse dies, if you choose this more expensive option).
The amount you get depends on your age and health. The younger you are, the less you’ll get as you’re likely to be in receipt of your annuity payments for longer.
Your income can be fixed or you can pay for it to increase in line with inflation. Opt for the latter, and your payments will be lower to start off with but will increase steadily each year. The longer you live, the better value an index-linked annuity becomes.
You can see the sense of a retirement annuity. It means you’re going to have an income for life, no matter how long you live
If you have an illness which is likely to decrease your life expectancy, or if you smoke, you might qualify for an ‘impaired life’ annuity, which pays a higher return because of the likelihood of you not being around to collect your payments for too long.
Brutal, but that’s how these things work.
To date, most people have split their pension pot at retirement, taking 25% as a tax-free lump sum (the maximum allowed) and using the rest to buy an annuity.
Annuity payments are taxable, so you’ll pay tax if your total income for the year exceeds your personal allowance.
What’s changing – and how are annuities affected?
You can see the sense of a retirement annuity. It means you’re going to have an income for life, no matter how long you live.
That’s why annuities were for so long a required purchase at retirement – the government didn’t want people running out of money in their retirement.
But resentment about the obligation to buy an annuity has grown in recent years because the returns have been so low. For many people, rates are below 5% - so £50,000 would buy you an income of less than £2,500 a year.
The actual rate you will be offered by an annuity company depends on your life expectancy and on the yields available on long-term government bonds, or gilts. Rising life expectancy and low gilts returns have proved a toxic cocktail.
The obligation to buy an annuity at the point of retirement has gradually been removed, and the changes which take effect in April introduce a new era of complete freedom and flexibility.
Independent advice – essential!
If you’re not sure whether or not an annuity is the right choice for you, it’s a good idea to seek independent financial advice.
Scott Mullen, director at My Pension Expert said: “Thanks to the Budget there are now even more options open to retirees beyond simply taking out an annuity, although this additional choice has led to the retirement process becoming more complicated than ever.
“An adviser can act as a guide throughout the procedure and ensure that the right product is selected, tailored to the specific needs of the individual at the best rate available.”
Someone approaching retirement now has to decide between the security of buying an annuity and the right to manage their pension pot as they see fit.
This has prompted concerns that some people will use their money irresponsibly – buying a flash car, perhaps, or going on an extended cruise.
But the counter argument is that it is their money, so they should be allowed to do as they please with it. There have been suggestions that many retirees will be tempted to use their pension savings to buy property as an investment.
Again, the most important decision anyone can make is to take their time, consider their options and take expert advice from a trusted source.
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