What type of pension funds can buy an annuity?
Not every pension arrangement can purchase a pension annuity.
A member of an occupational final
salary pension scheme is provided an income from the
employer based on the final salary and years of service.
Although it is possible to transfer from this scheme to
a private pension arrangement, this process would be subject
to passing the GN11 test.
Certain pension arrangements must buy pension annuities.
These include a personal
pension, stakeholder pension, retirement annuity policies
(RAPs), section 32 policies and free standing additional
voluntary contribution (FSAVC) plans. If the pension is
an occupational money purchase scheme the scheme trustees
can buy an annuity on the members behalf.
Is a retirement income always guaranteed?
Once a pension annuity or purchased life annuity has been
bought the income is guaranteed for the life of the annuitant.
If this has been established as a joint
life pension annuity, the income will continue at the same
income level or as a reduced dependents or survivors pension
for the whole of the spouses life.
protection is offered by the Policyholder Protection
Act 1997 (PPA 97) in the event of the insurance company
becomes insolvent. In this case 90% of the income provided
retirement or pension drawdown has been opted for
by the individual, the residual pension fund is likely
to be invested in equities or fixed interest securities.
In this case the fund value can go down as well as up
so the future income is uncertain and could reduce. This
also applies to other options such as a unit-linked annuity
or open annuities.
Can a tax free lump sum portion be taken from the whole
Since Pension Simplification from 6 April 2006, all pensions
can commute tax free lump sum on the 25.0% of fund value basis
for an occupational final salary and money purchase
schemes including the protected rights portion.
There is an absolute limit to the amount of tax free cash as this is subject to the Lifetime Allowance which is a total fund of £1.5 million in
the 2006/07 tax year rising to £1.8 million in the 2010/11 tax year. Currently the limit is £1.8 million for the 2010/11 tax year and the maximum 25.0% tax free lump sum that can be taken at retirement is £437,500 with any amount in excess of this figure attracting a tax charge.
The balance of the pension fund must still be used to purchase a pension annuities at retirement. The individual has the option to search for the highest annuity rates using an open market option, however, before making a decision at retirement, learn more about annuities, compare annuity rates and secure a personalised annuity quote offering guaranteed rates.
Privious to A-Day tax free cash could be taken only from the non-protected rights portion with, at the time, the exception being personal pensions taken out before 27
July 1989 where 25% could be taken from the pension fund
including protected rights, but excluding transfers in
from an occupational pension scheme and that portion of
the fund used to purchase a survivors
pension or dependants benefits.
Why is the annuity offered by my provider such poor
value compared to an open market option?
Providers of pension arrangements have a legal obligation
to offer annuities to individuals at retirement, whether
they are in this market or not. There is also a compulsion
for people to buy a pension annuity with at least 75% of their
fund when they do retire and take their pension
As 2/3rds of people retiring buy the pension annuity offered by
the provider anyway, even if it is up to 30% less than
market option from a competitor, pension fund providers
do not feel they need to offer good value for money.
How can an open market option offer
a higher income than my provider?
Some providers specialise in offering annuity products.
They could provide the whole range or specific types of
annuities such as a compulsory purchase annuity (pension
annuities), purchased life annuity and impaired or enhanced
annuity for both pension and life products.
The provider can use the pension annuity market to balance their
overall liabilities. For example, all policies involve
paying money out at some time in the future, whether they
are investments, endowments or life assurance. A disaster
at an industrial plant could mean a sudden claim of millions
against the providers life assurance if there are many
deaths. Pension annuities can provide a large amount of money
quickly with a relatively small cost in the short term.
Many providers only offer very competitive annuity rates
when they need to improve cashflow, as annuities can attract
tens of millions of pounds per month to a single insurance
company. This could occur if the provider has a large
number of maturing endowments and rather then sell investments
(possibly at the wrong time) to pay out the maturing claims,
improve some or all of their annuity rates to attract the capital sum to
meet these obligations. This could mean offering good
rates for a single week only.
When a pension annuity is purchased the provider takes about
4% as a charge initially paying 1% to 1.35% to an intermediary,
thereby improving liquidity, and invests the balance.
Over time some annuitants die early and do not receive
their original capital returned as payments, thereby creating
a mortality profit for the insurance company. Some of
this is returned to future annuitants in the form of higher
To find the providers that are offering the best rates
at any particular moment,individuals must seek an annuities
and pension firm offering specialist
advice of an independent financial adviser (IFA)
that has the qualification K10 (retirement options).
Could my pension provider offer a competitive enhanced
or impaired life annuity?
It is unlikely that the existing pension provider can
offer a competitive enhanced or impaired
life annuity, if they offer one at all. As 2/3rds
of people at retirement accept the rate offered by the
provider without considering an open market option that
could add up to 30% more pension income to a standard annuity, there is little incentive for the provider to
There are only a small number of life companies that offer
enhanced or impaired life terms and the only way to secure
income is to exercise the open
market option. In most cases it is possible to get
a free quote of the best pension annuity at that time and this
could increase the pension income substantially. Once you have purchased an annuity it cannot be changed, so always secure a personalised annuity quote offering guaranteed rates and research your options.
How ill do you have to be before receiving an impaired life annuity?
An individual aged 50 to 75 could be healthy now but due
to their lifestyle have a reduced life expectancy. For
example, they may have smoked 10 cigarettes per day for
the past ten years and could qualify for an enhanced
annuity. A smoker could receive up to 25% more income from a pension annuity depending on their age.
May be the individual has been a manual worker most of
their working life or lived in a particular location and
this could mean they qualify for enhanced terms. For a
more serious illness what is important is how this reduces
the life expectancy of the individual, even if they can
get around and do things today. So for impaired life
annuities the medical
conditions as well as the age are taken into account
by the underwriters.
If I don't want a conventional annuity income, are
there any other options?
This depends on the size of the pension fund on retirement.
Other options involve taking some risk and this means
a larger fund is required. For example, an individual
could transfer a fund, usually recommended to be £100,000
or more, to a pension
drawdown plan where a tax free lump sum can be taken
immediately. The balance can provide a variable income
between Inland Revenue set levels and the fund can be
invested in equities for growth.
Other options could be a with-profits
annuity or unit-linked annuity where the individual
chooses the income from the annuity. A with profits annuity
pays at a bonus rate which could go down if the income
level chosen is too high, but ultimately the income is
smoothed out over time. A unit-linked
annuity carry a much higher risk as they are dependent
on the performance of the equity market and the annuitant
should have other sources of income.
For those with £250,000 or more, an open
annuity can offer the greatest flexibility of income
for the individual and spouse while they are alive with
the opportunity to pass the residual pension fund to their
beneficiaries on their death. The underlying assets are
invested in equities so there is a higher risk with
open annuities. However, due to the large initial investment,
an open annuity may be more attractive to people with
a self invested personal pensions (SIPPs)
If I buy an annuity and die shortly afterwards, will
there be any money for my beneficiaries?
For both a compulsory purchase annuity (or pension annuities)
and a purchased life annuity a survivors pension and dependents income
can be selected to provide an income for a spouse or children
under the age of 18 years.
However, if these options are not selected, then on the
death of the annuitant there can be no capital for the
beneficiaries. This results in a mortality
profit for the life company of which part of the profit
is used to improve annuity rates for future annuitants.
It is possible to buy an open
annuity where the beneficiaries can receive any residual
pension fund on the death of the annuitant but this would
require a minimum investment of £250,000, and therefore
out of reach for the majority of individuals.
What are the disadvantages of waiting to take an annuity
An individual with a personal pension could leave the
money until they are aged 75 before having to buy annuities,
if they do not need the income, or transfer to a pension
drawdown plan, take a tax free lump sum and a smaller
There are risks associated with doing this. The equity
markets could fall further and thereby erode the pension
fund value. The future
trend could be that the annuity rates will fall and
this would mean a lower income from the pension fund.
Also, by not buying annuities the individual does not
benefit from the mortality profit. This means that mortality
drag impacts on a pension fund the investment return
must be greater, usually by 1% compound each year, in
order to match the income produced by an annuity.
Are annuity rates expected to rise in the future?
The expectation is that annuity rates will remain at their
current levels or fall in the future. This is because
of a number of economic factors. The rate of inflation
in the UK is now under control between the range of 1.5%
to 3.0% reducing the yields from investments and gilts
which are purchased by the insurance companies to pay
annuity income to annuitants.
The UK Government uses the gilt market to raise money
to increase public expenditure. It does this by offering
attractive rates of interest, but currently this money
is not required. The market expectation is that the UK
will eventually joint the Euro. As the interest rates
in Europe are lower than in the UK, this means that UK
interest rates must fall to match that of Europe.
Finally, in the past there was only a single annuities market
where the early death of an annuitant resulted in a mortality
profit for the other annuity holders. However, these annuitants
are now selecting against the insurance companies by opting
for an enhanced or impaired
life annuity, phased retirement or pension fund withdrawal.
This has the effect of reducing the mortality profit and
hence the annuity rates.