Money can’t buy you love.
The famous song was right. What money can buy you, however, is security – the security of a retirement income guaranteed for the rest of your life.
For ‘guarantee’ read: peace of mind.
Today we’re looking at annuities, those insurance policies that turn your lump sum into a monthly income that you can rely upon until the day you die. An annuity has been described as a ‘mortgage in reverse’ – you pay the insurance company a lump sum, and they pay you back your capital, plus interest, over a period of time.
Annuities have had bad press over the past few years, due to low rates, but they’re now rallying – Canada Life were quoted in the Sunday Telegraph as saying that annuity applications were up 20% in the second half of 2021.*
Many people value the guaranteed income aspect of an annuity, which is partly why they’re making a bit of a comeback. Claire Altman, managing director of individual retirement at Standard Life, part of the Phoenix Group, explains: “With [defined benefit] provision continuing to decline, stock market volatility on the rise, and people continuing to underestimate their own longevity, annuities can play a valuable role in providing income certainty.”
It’s true that taken alongside your state pension, an annuity can form a substantial part of your retirement income.
Let’s take a closer look at them
Until 2015, buying an annuity with your pension savings was compulsory. Now, however, once you reach 55 you can take the first 25% of your savings tax free, and take, or ‘draw down’ the rest as taxable income, as quickly or slowly as you please. (Be careful not to take too much in any single tax year, though – you could end up paying the higher rate of income tax for the first time in your life!)
Suppose you decide to take your 25% tax-free lump sum – perhaps go on that world cruise you’ve been dreaming of – and buy an annuity with the remaining 75%, to give you a guaranteed income for life.
This is where it gets tricky, and you would do well to act only with financial advice. When you buy an annuity with your pension savings, it’s gone. You can’t have your money back, or change your mind about your decision. This is why it’s crucial to consult an adviser who will ensure you make the right choice.
The first point to make is that you don’t have to, and indeed you shouldn’t immediately accept, the first annuity offer you get, probably from your own pension company. The law guarantees you your ‘Open Market Option’ or Omo, which is the right to shop around for the best deal.
Now let’s look at the other types of annuity you can choose from
Level annuity: this is the plain vanilla version, it pays out until you die and then it stops. The disadvantage is that if you die shortly after taking one out, your money is lost.
Investment-linked annuity: your money is invested in the stock markets, and your monthly income fluctuates according to market performance. You risk that you may get less, in the hope that you get more. There’s usually a minimum below which your income cannot fall.
Joint life annuity: this continues to pay out to your spouse (although possibly a lower amount) after you die.
Guaranteed annuity: guarantees to pay out to you or your partner for an agreed number of years (usually five or 10) even if you die. It stops paying after the agreed term, even if you’re still alive.
Escalating annuity: rises in step with the cost of living so that your spending power isn’t eroded by inflation.
Fixed-term annuity: this provides a guaranteed income for an agreed number of years or until you reach 75, at which point you receive an agreed lump sum and can do what you like with it.
In terms of buying annuities, you can mix and match if you like. You could, for instance, buy a level annuity and also an escalating annuity, thus mixing your levels of risk.
Bear in mind that annuity payments are classed as income for tax purposes, and so will be taxed at 20% or 40%, depending on your income.
If you value the security and peace of mind that comes with a guaranteed income for life, or even beyond, then an annuity could be just the solution for you.
We’d be happy to chat to you about it in more detail.
* Sunday Telegraph, Money section, page 1. Saturday 30 July 2022.
This article was prepared by AdvisorStream and is legally licensed for use by AdvisorStream.