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What is an annuity?

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

An annuity is a deal in which 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 can help 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.  

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.  

Will you pay tax on your annuity?

It is important to know how your annuity is taxed. Although your balance keeps growing free of tax, the payments you get from your annuity will be subject to income tax.

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.

Is there another option for my pension?

When it comes to your retirement and financial wellbeing, you need 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 as you like. 

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, your savings could continue to grow, while offsetting the impact of inflation, which eats into the purchasing power of your cash.

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. 

Photo by Ceci Bravo on Unsplash

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