5 key things you should know about annuities when creating your retirement income

Are you concerned about whether you can afford to retire, or afford the lifestyle you want in retirement. For many people, the state pension is not enough, and they need additional retirement income to support travel, spoiling the grandchildren, or staying in the home they love. Saving enough money can be a challenge, especially if costs of living are rising.

Annuities are one way to help you create solid, sufficient income in retirement, but you need to understand some key things about them in order to leverage them properly and make sure you can sustain your lifestyle in retirement.

So, here are four things you should know:

Purchased Life Annuities vs. Pension Annuities

If you have one of these annuities, you need to know the difference for tax purposes.

Purchased life annuities are an insurance product. You pay a lump sum and then get an annual payment for life, or for a fixed period. Typically your heirs will get any remaining money when you die (assuming it’s within any fixed period). This is basically an investment vehicle, and any income is taxed as investment income. Purchased annuities do not have to be bought with pension money.

Pension annuities are considered pensions and are taxed as pension income. The first 25% is tax-free. You have to spend money from your pension pot on these, making purchased annuities the better choice if you don’t have a good pot already. If you do, however, pension annuities tend to give a better return.

You should talk to a tax advisor about which option is likely to be most beneficial to you.

Fixed Versus Increasing Annuities

Once set up, an annuity cannot (usually) be altered, but there are options prior to that decision being made. If you select a fixed term annuity, it will pay out on the terms agreed at outset for a fixed period of time. At the end of the term there could be a maturity amount, which is also set up at outset. These can be used to fill an income gap before State Pension Age. All other annuities are paid out for the life of the policyholder and the terms can differ.

There are basically four types of payment:

1. Level. With a level annuity you will get the same income each year, typically at a higher starting amount. However, they don’t take into account inflation or increases in your cost of living due to mobility issues or failing health.
2. Escalating. Escalating annuities start lower, but increase at a fixed rate each year, such as 3%. This provides some allowance for inflation, but may not be enough of a cushion during volatile periods.
3. Inflation-linked. These start at a low level, but rise each year in line with the retail price index. Inflation-linked annuities are better for people who expect to live longer and get a benefit over an extended period of time.
4. Impaired or enhanced. With this type of annuity they pay out more if you have health issues that may shorten your lifespan, such as diabetes or high blood pressure. The income rates are often considerably better, but they work on the assumption you won’t be around long.

For most people, an escalating annuity is the best option, however, the starting income is significantly lower. You should talk to an expert about which is really best for you.

Protecting Your Spouse

You may want to ensure that your spouse continues to get the money after your death, especially if they are younger or healthier than you. A joint life annuityoften provides lower income but that income will continue through the life of the surviving spouse.

Lifetime versus Fixed Term

A lifetime annuity lasts until you die. You can’t cancel a lifetime annuity. You have essentially spent that money in order to get it back later, and if you find that it is not increasing enough to cover your costs, you will have to seek other ways to increase your income.

There’s also the risk that you might get less back than you paid if you die earlier than expected, and only some annuities give the remaining money back to your estate. A lifetime annuity thus might not be the best choice if you are in poor health. However, you don’t have to do any reinvestment and if you are healthy, you can get substantially more money than you paid in.

A fixed-term annuity, on the other hand, lasts a set number of years. The max is 40 years, but most fixed-term annuities are 5 to 10 years. The money you pay in is invested, and you get not just the regular income but a lump sum at the end that includes the interest. You can then use it to buy another annuity, do a pension drawdown, or make a large purchase. Fixed-term annuities mean you can benefit from improved terms in the future and give you more flexibility, but may not be as stable as a lifetime annuity.

Note that you can potentially have both! You can put part of your pension in a lifetime annuity to pay certain bills, and part of it in a fixed-term annuity.

Where To Find More Information

It’s not possible to cover everything about annuities in one blog post and you should talk to a financial advisor about the best option for you.

However, we do have some more information that may help you make the right decision.

Our Money Alive video boxsets provide lots of information in an easy-to-digest video format. Check out our box sets on Annuities and Flexibly Accessing Pensions. These box sets are free, interactive, and cover all kinds of options for guaranteed income in your golden years.

As you can see, annuities are complicated! But they’re one of the best ways to effectively use your pension pot when done correctly. If you’re getting older and thinking about buying an annuity, one of our experienced advisors can help. Contact us to find out more about how we can help you choose the right annuity option for you and your family.

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