Should you cash in your annuity?

It was widely expected, and the Budget confirmed it: up to five million pensioners will be allowed to ‘cash in’ their annuities from April next year.

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The proposals, which will enable those receiving income from an annuity to sell the right to that income for a lump sum, will give existing pensioners the same freedom already granted to savers approaching retirement.

They will be able to take more of their pension pot as a cash lump sum after April 6, 2015.

So what should you do, if you’re in receipt of an income from annuity? Here’s a look at the main considerations…

Fighting low rates

An annuity offers financial security at retirement because it provides a guaranteed income for life.

Traditionally, retirees have been obliged to use the bulk of their accumulated pension savings to buy an annuity at the point of retirement because it meant they would never run out of money

But annuity rates have been painfully low for some years, triggering massive resentment among pensioners.

This is hardly surprising when you consider that a 65-year-old man would need a fund of £1m to secure an annual inflation-linked income for life of just £27,000.

Clearly, annuities do not represent good value for many savers – hence the mooted changes in the Budget.

To make matters worse, once you have made your annuity purchase, you’re effectively trapped. Under the current system, you cannot cash in the annuity without incurring a hefty tax charge of 55% - and even up to 70% in some cases.

Concerns are growing that people will short-change themselves simply to get their hands on a chunk of cash”

Secondhand annuity market?

The government is now consulting on proposals to open a secondhand market in annuities in 2016.

This would enable pensioners to sell their annuity to the highest bidder, probably an insurer or pension fund, forfeiting their right to an annual income in return for a cash lump sum.

Most experts welcome the reforms in principle, but warn there is no guarantee pensioners will get a good deal.

Tom McPhail, head of pensions research at Hargreaves Lansdown, says: “It is hard to see how reselling an annuity can magically generate extra yield for the policyholder. The capital sum they receive will only ever be at best the net present value of the future income stream.”

Add in the crude fact that the institution buying the annuity will want to make a profit (just as the institution which first sold it will have done), and you can see why concerns are growing that people will short-change themselves simply to get their hands on a chunk of cash.

Potential losses

Some calculations suggest you could lose out by as much as 30%.

For example, Andy Tully, pensions technical director at financial firm MGM Advantage, says: “The issues are complex but I can’t see how exchanging an income for cash upfront at a significant discount would make sense.

“From our calculations you could lose 30% or more of your potential income because of costs and upfront tax.”

Tax considerations

The tax issue is crucial. At the moment, tax is set at 55% to deter people from cashing-in their annuity.

Under the pension freedom proposals, people would still be taxed, but only at their normal rate for the year they sold their annuity.

If their total income for the year (including the proceeds of the annuity sale) was below the higher rate tax threshold – roughly £42,500 in 2016/17 – they’d pay tax at 20%. But if the annuity sale pushed their income above the threshold, they’d pay 40% tax.

Wrong decision

McPhail says there is a danger that pensioners will make the wrong decision: “The attraction of a short-term cash payment may well outweigh the guarantee of a long-term income, but pensioners may not always be well-equipped to choose which option offers the better value.”

Tully agrees. “It would seem crucial that people should be compelled to take advice before making this decision,” he says.

There’s also the ominous threat of unscrupulous firms charging excessive fees to ‘help’ people exchange their annuity income for a cash sum. Numerous scams have already occurred linked to people approaching or at retirement.

Government action

The government recognises the risks and has pledged to work with the Financial Conduct Authority, the City regulator, to ensure that safeguards are in place to protect consumers.

It might, for example, offer guidance through the new Pensions Wise service. But Malcolm McLean, senior consultant at Barnett Waddingham, is not entirely convinced: “It is clear the government is concerned that there is a real possibility of consumer detriment. Adequate guidance and protection arrangements must be in place if this is to be avoided or at least minimised.

“Whether Pensions Wise has or will have the capacity to deal with this extra task is debatable, and much will depend on how the new service develops throughout the coming financial year.

“At this point in time, regulated advice, although clearly desirable, might be too expensive for many people. Risk warnings from pension firms will therefore be essential in addition to the other methods proposed.”

Cost of freedom

The new freedoms give people greater choice over their pensions, but they will not suit everyone.

McLean says: “Although there will undoubtedly be some people who could benefit from exchanging their annuity for cash, the likely poor deals on offer and the complexity involved may make this new extension of the freedoms unsuitable for the majority of existing annuitants.”

So the bottom line is this. Before you trade your annuity income for a lump sum next year, scrutinize the details and work out how much it’s going to cost you. And think long and hard about how you’ll manage financially in the years to come if you no longer have an annuity income on which to rely.

Remember that, while buying an annuity is an irrevocable decision, selling one is likely to be the same. In other words, once you’ve sold your income, it’ll be gone for good.

Please note: any rates or deals mentioned in this article were available at the time of writing. Click on a highlighted product and apply direct.

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