Is the annuity dead?
This article by Jon Drysdale, an independent financial adviser for PFM Dental, was first published in Scottish Dental Magazine November 2016.
When the NHS was founded in 1948, the life expectancy for men retiring at 60 was 66, and for women, 71. Those figures are now 82 and 85 respectively, which is why legislation in 2015 forced public sector pension schemes to link their retirement age to State Pension age.
What are annuities?
An annuity is an income for life and you can buy this with your pension fund at retirement. However, if you are approaching your personal pension retirement age (often set at 55, 60 or 65) an annuity may not be the best option. In past years, pension rules compelled you to swap your fund for an annuity. Now you can take income from your pension any time from age 55.
Annuities rates are falling
When you buy an annuity you give up your pension fund in exchange for a fixed (or increasing) income. If you live longer than average, you gain. Die sooner and you lose out. As life expectancy continues to increase, annuity companies compensate for having to pay incomes for longer by lowering the rate they pay. Building in guarantees (in the event of premature death) might offer some reassurance against the gamble but further reduces the initial rate you get. Likewise, adding inflation protection reduces your annuity rate. Annuity rates are also affected by government bond (gilt) yields as these are the financial instruments that providers use to support your annuity.
Annuities can’t be passed to the next generation
A pension can be left to the next generation (by nominating beneficiaries) usually free of inheritance tax. Once annuity income starts, you lose this option.
Annuities don’t offer Lifetime Allowance flexibility
Taking annuity income will trigger an HMRC Lifetime Allowance test. Personal pensions allow this test to be deferred until age 75 or triggered when you choose. You may wish to do this if your overall pension values (including NHS) are approaching £1m. As an example, an annual NHS pension of £43,000 taken at age 60 will use up the £1m allowance. Subsequently triggering an annuity could result in a charge of 25 per cent plus income tax. There are ways of managing this through a phased withdrawal of tax-free cash or income, only achievable by leaving your pension invested.
Annuities attract income tax
Annuity income is subject to income tax. Withdrawal from pensions (known as drawdown) can be tailored to suit your income tax position. For example, you can defer drawing income until your self-employed income has reduced. Drawdown can facilitate a phased withdrawal of tax-free cash whereas annuities cannot. Funds that aren’t required remain invested. This may enable your pension to grow further and supply a greater income in later years or allow for a fund to be passed to the next generation.
What about annuity guarantees?
Many pensions and usually those pre-2000, offer guaranteed annuity rates. e merits of these are varied and you should always check with your pension provider or your adviser what conditions apply to the guarantees.
While a guaranteed rate might be in excess of prevailing market annuity rates, this doesn’t mean it is the most suitable option.
Careful consideration should be given to the alternative income options that pensions offer before committing to an inflexible gamble on life expectancy. e value of the guarantee requires careful assessment and advice is recommended.
In summary, an annuity is the fixed lifetime income that you exchange your pension fund for when you retire. Expanding life expectancy, low interest rates and falling gilt yields have contributed to a steady decline in annuity rates. I recommend you seek advice on technical issues, such as the Lifetime Allowance, or where you need to consider the value of a guaranteed annuity rate.