Post Retirement
Retirement Options
An annuity provides an income, either for life or for a specified period, in exchange for a lump sum investment. Once the annuity has been bought, you cannot get your lump sum back and you are tied into the income agreed. The level of income that you will receive from an annuity depends upon:
- How much you invest
- Your age
- Your health
- Sex
- The prevailing annuity rates at the time you invest.
The older you are the more pension annuity (income) you will receive. Once you have bought an annuity, the income you will receive will be stipulated for either the rest of your life, or the term of the annuity. The joker in the pack though, is the fact that annuity incomes rates vary so much over time, & from provider to provider, just like bank & building society rates.
How they work
Annuities are supplied by life offices. Like most organisations, life offices exist to make a profit. They will endeavour to do so out of you. The income you will receive from an annuity is dependent upon many things, such as the investment conditions at the time you take it out. Most, but not all, annuities offer some form of guaranteed income. To support this guarantee, the life offices invest in fixed interest investments, usually long term government gilts. The rate of return of these gilts varies over time & so therefore do annuity rates.
Another big influence is your age. The insurance company will adjust the payments it's offering you, depending upon how long it expects you to live. It follows that if you buy an annuity at 75 you will secure a much better rate than you would at 55. In addition, women, statistically live about seven years longer than men, so again women tend to attract lower annuity rates than men. However, certain annuities, like the ones funded by 'appropriate personal pensions' are calculated on a unisex basis, with both men & women receiving the same rates.
Health can also affect an annuity's rates. Someone suffering from a fatal disease will often secure higher rates since the insurance company will expect to pay out for a shorter time. The major drawback of traditional annuities is that the terms are set & cannot be changed once you've handed over your lump sum. This is obviously a disadvantage if you happen to be retiring when rates are low. To counter this, there are now methods of phasing your retirement, to allow you greater control over when you commit to an annuity.
There are two main types of annuity.
Compulsory purchase annuities (CPA's) must, and can only be bought with the bulk of the proceeds from a money purchase pension, such as a personal pension plan or the proceeds of a money purchase employers scheme.
Purchased life annuities on the other hand, (PLA's) can be bought by anyone with spare capital. The difference between the two is that with CPA's, the full income is taxable whereas with PLA's, only the interest element is taxed. The element of income that represents a return of capital is not taxed.
Hence, a tax-free lump sum from a pension will for some people, produce more income via a PLA, than if it had been left with the rest of the pension fund & purchased a CPA.
Annuities: The options available
It is important to understand the options available to you when you buy an annuity. Like all things, there are pros & cons to each. Which option suits you depends upon your circumstances and attitude to risk.
Level Annuity
Income will not increase in payment. It provides the owner (annuitant) the highest income at the outset compared with other options, however as time goes by & inflation eats into it, the value of the pension, in real terms, decreases. In the case of someone who retires early, then lives a long time, this reduction in 'buying power' could be very considerable.
Joint-Life Basis
With this option, either a full or a reduced income will continue to be paid to the partner if the annuitant dies, because women tend to live longer than men, a wife several years younger than her husband could reduce the income payments significantly. The same is true of the reverse. Married couples usually take out joint life annuities, especially when the spouse has no other independent pension income.
Guaranteed Annuity
It is possible to ensure that the income to be paid is guaranteed at a set level for a period after the death of the annuitant. Typical guarantee periods may be 5 or 10 years. This option usually reduces income, depending upon your age & how long the guarantee is. If the annuity is on a joint-life basis, & both parties die within the guarantee period, the payments continue to the estate.
Escalating Annuity
These provide an income that will increase annually at a predetermined rate, or sometimes in line with the retail price index. The advantage of this is the income provides some protection against inflation. However, the initial income will be less compared to a level annuity.
With or without overlap
Applicable when a joint life guaranteed pension has been chosen. With overlap, the spouse/dependent's pension will commence immediately upon the annuitant's death. Without overlap, the pension will commence at the end of the guaranteed period or immediately upon the annuitants death, whichever occurs latest.
With Profits & Unitised Annuities
Traditional annuities provide a guaranteed income in one form or another, however there are other types now available, namely with profits & unitised annuities. They differ from traditional types in as much as the guaranteed element is either reduced, or taken away altogether in exchange for the possibility of increased income in the long term.
With a with-profits annuity, you initially secure a low guaranteed income and then you get annual bonuses from the with-profits fund. These fluctuate from year to year. You can lift the initial income by anticipating the future return of bonuses, kind of betting on them, however if the actual declared bonus rate is then lower, your income will drop, & vice versa.
Under a unit-linked annuity, no guarantees are provided. The income you receive is dependent upon the underlying performance of the fund. It can & does fluctuate considerably. With favourable market conditions, a unit-linked annuity may, in the long term, produce income that exceeds that of a traditional level or escalating annuity. The problem is that the reverse is also true, adverse conditions could decimate the value of your pension.
Legislative changes in 1999 (PSO Update 54, published on 30 June 1999), permitted trustees of money purchase occupational schemes to offer income withdrawal when benefits become payable. This allows an amount to be drawn from the fund each year between minimum and maximum levels, whilst putting off buying an annuity until no later than age 75.
The amount of pension income you can buy from an annuity has fallen sharply in recent years. Annuity rates - which decide how much annual income your pension fund can buy - are linked to the yields on gilts, which the government uses to borrow money.
Once you buy an annuity, you are stuck with it and the income it provides for the rest of your life. Once you are in, you can't switch out again.
Income drawdown lets you put off buying an annuity, although there is no guarantee that annuities will necessarily get better.
Income drawdown can pay an income broadly similar to what you could have got from an annuity while at the same time leaving your money invested.
Your money may be invested in stocks and shares, property, bonds and other investments while you take your income direct from your pension fund. You have to do this to try to get enough growth both to pay your income now and to keep the value of your fund so you can afford to buy a decent annuity income later on, but no later than age 75.
The amount your pension fund needs to grow by to achieve this is called the "Critical Yield". You will have to decide on your target income at the outset. To have a realistic chance of reaching it you will most probably have to put your money into stocks and shares, which can be riskier than other investments.
You will also have to decide at the outset at what age you want to switch from your drawdown plan into an annuity. How long you decide to take an income for before purchasing an annuity will have a big impact on the critical yield you need to earn.
Opting to take income drawdown means you give up the security that annuities offer.
The maximum income withdrawal is determined by applying a Government Actuary Dept (GAD) annuity factor to the fund (net of any tax-free cash taken). The minimum withdrawal is 35% of the maximum. Maximum and minimum levels are reset every three years. Maximum benefit checks are carried out when benefits commence and when the annuity is purchased and any surplus must be returned to the employer less 40% tax.
The income drawn may vary from year to year between the 35% and 100% limits provided it does not exceed the Inland Revenue maximum. On death during income withdrawal, benefits are paid on a death in retirement basis i.e. the remainder of any guaranteed period plus a spouse /dependant's pension if applicable. Income withdrawal may not be used if the benefits include protected rights, GMP or reference scheme benefits.
Phased Retirement pension plans allow you to cash-in your pension fund in stages. You choose how much to cash-in and when to do it. The funds you don't encash remain invested and can provide the highest levels of death benefits. Income from Phased Retirement plans is made up partly from tax-free cash, so the plans can be used as part of tax and estate planning.
Eligibility
Phased Retirement is available to anyone between the ages of 50 and 75 and who has a personal pension plan. If you are in a company pension scheme or other type of pension, it may be possible to transfer your pension to a personal pension plan and consider Phased Retirement.
How it works
The tax-free cash sum payable at each stage is a proportion of your overall entitlement. In the early years, the tax-free cash sum makes up a large proportion of your overall income.
Naturally, as the first encashments are normally small in relation to your total pension fund, the income produced from the annuities, or Drawdown investments, in the early years is likely to be low. Bear in mind though, that any annuity or Drawdown income you do buy will continue to build up each time you make encashments. Therefore, as time goes on, the income from annuities or Drawdown starts to form your main income. In any event, under current legislation, you must buy an annuity by the age of 75.
How is my income taxed?
While your pension fund is being invested and you are not drawing on it, its investment growth remains free of Capital Gains Tax in a tax efficient environment. Once you vest a segment, you receive a tax-free portion and the remainder purchases either an annuity or a Drawdown investment. Either way, you only pay tax on actual income received from the annuity or on the amount; you elect to withdraw as income from the Drawdown investment. Tax is deducted at source and you would be assessed at the end of the tax year by the Inland Revenue to check on your tax rate.
Purchasing your annuity
At any time in the future your pension fund can, in whole or in part, be converted into an annuity. Even at the outset, you may decide to purchase an annuity with part of your pension fund.
What happens when I die?
On your death, your surviving spouse may receive the entire remaining fund (i.e. the funds which have not yet been encashed to provide tax-free cash, an annuity or Drawdown), with no taxes imposed and normally totally free of Inheritance Tax.
This is the case if your funds did not come from an occupational scheme. If they did, your spouse may only receive a lump sum equal to 25% of the fund, with the remainder being used to provide an income, usually by means of an annuity.
In addition to any remaining fund in your Phased Retirement plan, your spouse or other beneficiaries may also receive income, and possibly a lump sum, from any annuities and Drawdown investments you have bought up to the time of your death.
As with Drawdown, you can write your Phased Retirement plan in trust. This should be effective to exclude your pension fund from any Inheritance Tax liability, and means you can direct payment to whoever you want (although this can also be achieved via a simple nomination form).
Pensions are intended as long-term investments. If you withdraw from this investment in the early years, you may not get back the full amount invested. Past performance is no guarantee of future returns and the value of units and the income derived from them can fall as well as rise. This information is based on our current understanding of tax law. Tax relief's referred to are those currently applying and their value depends in the individual investor and/or the funds involved. Levels and bases of taxation, and tax relief are subject to change. Investment income of pension schemes is currently free from all UK taxes although pension funds can n