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What is an annuity?

Pension freedoms have unlocked new opportunities for savers looking forward to retirement. This has put the traditional annuity in the shade, but can it can still play an important part in reliable financial planning for retirement?

Before pension freedoms, buying an annuity used to be the only option for Brits that had a saved into a defined contribution scheme – where you and your employer both contribute to your pension.   

An annuity is where you swap your pension pot for a guaranteed regular income until you die. In a time when people are living longer but saving less, this helps alleviate fears that you may run out of money in old age.

The income you get from your annuity is expressed as a percentage of the amount you transfer. For example, if you had £200,000 of savings and are offered an annuity rate of 5%, you’ll get £10,000 a year.

How is my annuity rate calculated?

When you swap your pension pot for an annuity, your provider invests your money in long-term government bonds. The rate you are then offered depends on the interest rate paid by the government.  

The returns offered by annuity providers have slumped over the last three decades, from nearly 16% in 1990 to just over 5%¹ in 2017. If you’d have had £200,000 of savings in 1990, you could have got around £32,000 a year.

Your annuity provider will take many things into consideration before giving you a quote, including your age, gender and lifestyle. If you have a serious health condition you’re likely to get a higher rate than someone who is expected to live for a long time.

Whilst you may prefer the income reliability annuities offer, you need to make sure you’re making the most of what you have. You only have one chance to buy an annuity that’s right for you.

Can you inherit an annuity?

Saving for your pension takes time, money and sacrifice, so it’s disheartening to think that your hard-earned money could go straight to your annuity provider when you die.

If you do want to pass on your pension pot, make sure you consider either a joint-life annuity or value-protected annuity. There are other annuity products available, including single-life and enhanced annuities.  

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You can also opt for a variable annuity rate over a fixed one, although these are complex products that will make your cash flow less reliable.

Will you pay tax on your annuity?

If you’ve built up your savings in a defined contribution scheme, you can take 25% of your pension tax free when you get to the age of 55. You don’t have to take the money, you can opt to exchange it for a larger annuity instead, although you may prefer the tax benefit.

You must pay income tax on your annuity income if your total taxable income, including state pension, personal pension and tax benefits, adds up to more than the £11,500 personal allowance in 2017/18. This is deducted through PAYE.

You may also have to pay tax if your pension pot exceeds the £1 million lifetime allowance.

Is there another option for my pension?

When it comes to your retirement, you need to take the time to ensure that you do what’s best for you and your family. Thanks to pension freedoms, you have more opportunities available to make the most of what you have.

An annuity is great if you’re happy to sacrifice potential return on your savings for the comfort of a reliable income.  

But many savers need more flexibility in retirement. Imagine you have emergency work you need doing on your house, or you want to go on a surprise family holiday, and you can’t access your pension savings when you like – it’s locked up until you die.

Income drawdown is another option for savers looking for a flexible approach to their retirement. You can keep your savings invested in the market and dip into it as you like. Of course, you need to make sure you don’t spend your savings treating the family in the first few years.   

By keeping your pension invested, you’re hoping the value of your savings will continue to grow – although it can also fall in value. It also helps offset the impact of inflation, which eats into the purchasing power of your cash.

1 What are the best annuity rates today? The Telegraph, May 2017

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