What is a pension annuity and how does it work?

WHEN you reach retirement, working out what to do with your pension pot is one of the biggest decisions you’ll have to make.

You don’t want to risk running out of money in later life.

You only get one shot at buying an annuity, so you need to get it right first timeCredit: Alamy

What is an annuity?

An annuity is a type of retirement product you purchase with the money from your pension pot.

It pays you a guaranteed income for life.

When you purchase an annuity, you can opt to take 25% of your pension pot as a tax-free lump sum.

The remainder is then converted into a taxable lifetime income.

The lump sum can be useful to cover bills, or if you need to clear any debts. You could even use it to move home or treat the family.

How does an annuity work?

The amount of income provided by an annuity will depend on a number of factors.

This includes the size of your pension pot, your age, health and lifestyle details, and also annuity rates at the time.

But shopping around is essential.

As you only get one shot at buying an annuity, you need to get it right first time.

In order to get the best value, you need to shop around as your current pension provider might not offer the most for your money.

What if I want more flexibility?

IF you want more flexibility about how much to take as income – and when – you may want to consider a different approach. So what are the alternatives?

Drawdown

These days, most retirees opt to leave their pension invested in the stock market, and take income as and when they need it, via ‘drawdown.’
As with an annuity, you can withdraw 25% as a tax-free lump sum, with the rest taxed in the same way as income.
Drawdown provides more flexibility than an annuity – and returns may be higher – but there are risks.
Savings are exposed to greater volatility. If there is a stock market crash, the fund value will fall, meaning your income needs may not be met. If you are considering drawdown, seek financial advice.

Take small cash sums

Another option involves you leaving your pension pot invested, and withdrawing lump sums as and when you need to. But note that not all schemes allow this.
There may also be limitations on the number of withdrawals each year.

Cash it all in in one go

If you so wish, you could close your pension pot and take it all as cash. But this will not give you a secure retirement option.
It could also land you with a hefty tax bill. Tread very carefully and seek advice.

Mix and match

Note that you are not limited to picking one option. You can mix and match as suits your needs.
This might, for example, involve using some of your pot to purchase an annuity, while leaving the rest invested and drawing an income from it. In many cases, a combination can work well.

Leave your pot untouched

If you already have enough income to live on, you might want to think about delaying taking your pension to allow a fund to continue growing.
By putting off retiring, you will have more money when you do eventually stop working.

Consider delaying your annuity purchase

Even if you decide not to buy an annuity when you retire, it could still make sense to do so at a later stage in retirement, as you are likely to get a better rate when you’re older.

What is an ‘enhanced life’ annuity?

If you have a health condition, such as cancer or heart disease, make sure you tell your provider, as you can get more income from what is known as an ‘enhanced annuity.’

The assumption is that your life expectancy will be shorter.

Being a smoker could also boost your rate.

What’s an ‘inflation-linked’ annuity?

Lots of providers will offer annuities that rise in line with prices.

This will ensure inflation does not erode the spending power of your annuity.

Note, though, that this may mean having to settle for lower income initially.

Until recently, at retirement, most people used their pension pot to purchase an annuity.

But things changed when the Government introduced its so-called ‘pension freedoms’ in 2015, allowing people to access their pension pot at 55.

Since then, savers have had a lot more choice about how they use their pension.

Does an annuity still make sense?

If you are looking for a stable income in retirement, and don’t want the hassle of managing your investment, you may still want to consider an annuity.

That said, as rates have declined, you now need a fairly hefty pension pot to generate a decent income (albeit recently, rates have shown some signs of improvement.)

How much income might I get?

At present, a £100,000 pension pot could buy a healthy, single 65-year-old man an income of around £4,300 a year with a basic annuity, according to the Money Advice Service.

If that same individual was in bad health, that figure would rise to around £5,500 a year.

This assumes the individual has taken the maximum tax-free cash lump sum of 25%, and used the remaining £75,000 to purchase an annuity.

To compare quotes using the MAS annuity calculator, head here.