Types of retirement options
After taking any lump sum, there are a number of ways to take an income from your money purchase pension. Some, such as an unsecured pension or phased retirement, may only be suitable if you have a large pension fund or other substantial assets and you are prepared to take some risks with your pension fund to get greater flexibility and a higher return.
Your options are:
- A lifetime annuity
- An unsecured pension
- Phased retirement
What if my pension funds are small?
If the total of all your pension funds is less than a minimum amount, you can take some or all of your entire pension as a cash lump sum, rather than taking an income. This is known as trivial commutation.
You must be between at least 60 and no older than 75 and all the pension funds which you want to 'commute' must be converted to cash within a 12 month period.
A quarter of the money you will receive is a tax-free amount; the rest will be taxed as income.
You do not have to 'commute' all your pension funds, but bear in mind that it might be difficult to get a retirement income from small funds because many annuity providers will not take funds below a specified minimum, e.g £10,000.
Lifetime annuities
A lifetime annuity converts your money purchase pension into an income for the rest of your life, however long that may be. Lifetime annuities are sold by life insurance companies and you can add different options and get different types depending on your needs and circumstances for example:
- To pay out your partner or spouse on your death; or
- an enhanced or impaired life annuity, which may give a higher income than a conventional annuity if you have an illness or medical condition, or you are a smoker.
How lifetime annuity pays out
The amount of income an annuity will pay depends on, amongst other things:
- The amount in your pension fund after taking any tax-free cash. You must take any tax-free lump sum before your 75th birthday.
- Whether your fund includes national insurance rebates because you contracted out of the additional state pension - you must buy a 50% spouse’s pension with the funds arising from national insurance rebates if you are married or have a civil partner.
- Your health or lifestyle - some annuities pay you higher than normal income if your health or lifestyle threatens to reduce your lifespan.
- Your age - the older you are the higher the income you will get. This is because, on average, an older person has fewer years left to live than a younger person.
- Because people are living longer, annuity rates are adjusted from time to time to reflect this. So if you delay buying your annuity you could be taking a risk and of course rates may rise and fall for various reasons.
- Your sex - usually the starting income from the same size of pension fund is higher for a man than for a woman of the same age. This is because, on average, the life expectancy of a man is less than that of a woman of the same age.
- The benefits you choose, for example:
I. Whether the annuity is for you, or for you and a spouse or partner, or
II. If the annuity is level or escalating, or
III. If it is guaranteed to pay out for a minimum number of years, even if you die during that time.
Single or joint-life lifetime annuities?
Before you buy a lifetime annuity you will have to decide if you want an annuity that will pay you an income for you only or one that can continue to pay an income to a spouse, partner or financial dependant after your death.
- Single life - A single-life annuity may be suitable if you don’t have a spouse, partner or any other dependency relying on you for financial support, for example, they have their own pension arrangement a single life annuity will not pay out to your spouse, partner or dependant after your death (unless there is a guarantee period - but this will only pay for a fixed number of years.
- Joint life - A joint life annuity will continue to pay an income to your spouse, partner, or dependant after you die for the rest of their life. If your financial dependants are children, the annuity will usually pay until they reach a certain age, which may vary.
After you die, the income paid to your spouse, partner or dependant will be a proportion of the income you were getting just before your death. You have to choose that proportion at the time you take out the annuity, and can be for example, 100%, two thirds or 50% of your annuity at the time of your death. A higher proportion will have a higher cost, and so your annuity income will be lower.
Be aware that:
- Joint life annuities are more expensive than single life, because the insurer will expect to pay an income for longer.
- Some annuity providers may not set up a spouse or partner's annuity if they are more than ten years younger than you, so check with the provider.
- Some occupational money purchase schemes insist that the income level is half of what you were receiving, so check with your provider.
- You should check with your provider whether your partner will be eligible to receive the income if you are not married or in a civil partnership.
- If you have a protected rights pension fund, you have to buy a joint life annuity paying a 50% spouse's pension if you are married or have a civil partner.
Top tips
1. Start thinking about your annuity choices at least four months
before you retire.
2. Don't forget to plan for your spouse, partner or financial
dependant if they rely on you for income.
Impaired life and enhanced annuities
Some companies offer annuities that pay you a higher than normal income if you have a health problem that threatens to reduce your lifespan. These are called Impaired Life Annuities. Relevant health problems might include, for example, cancer, chronic asthma, diabetes, heart attack, high blood pressure, kidney failure, multiple sclerosis or stroke.
You might be able to get an enhanced annuity if you are overweight, or smoke regularly. Some companies also offer higher rates to people who have worked in certain occupations or who live in certain areas of the country, so shop around and compare the income you can get from different providers.
Level or escalating lifetime annuities?
You can also choose whether you want your single or joint life annuity to be:
- a Level annuity; or
- an escalating annuity.
A level annuity pays you the same income year after year for the rest of your life. Level annuities have a higher starting income than escalating annuities but what you can buy with the income from a level annuity falls as prices rise. To protect your income from rising prices, you can choose an escalating lifetime annuity that pays a lower initial income but then increases each year.
There are two types of escalating annuities:
- Fixed-rate escalating annuities - your income is guaranteed to rise each year by a fixed amount, e.g 3%
- RPI-linked escalating annuities - your income is adjusted each year to reflect changes in the Retail Prices Index (RPI), so will rise and fall.
With an escalating annuity, the starting income is a lot lower than you would get from a level annuity. It would take around 14 years for the 3% escalating annuity to catch up with the level annuity. It would take 26 years before the total you received from the 3% escalating annuity exceeded the total paid by the level annuity.
Shopping around for lifetime annuities
Annuity rates vary from life company to life company, so you should make sure that you shop around to get the best deal for you.
- If you’re getting a pension from a personal pension arrangement, your pension provider should give you an estimate of the value of your fund about six weeks before you retire. Your pension provider should also tell you what income it would be prepared to offer you if you have bought an annuity from them. You can use this to compare products from other providers. This is known as your open market option.
- Don’t assume the same company with which you built up your fund will automatically offer you the best rate. It may be better to shop around and check whether another provider could offer you more. The annuity rate you get can affect your income by hundreds of pounds a year for the rest of your life.
- If you’re getting a pension from an occupational defined contribution pension scheme, the trustees may buy your annuity for you, but you can also shop around on the open market and find the insurance company with the best annuity rate for you, or your scheme trustees can do this for you if you ask.
It can be difficult or impossible to change your lifetime annuity provider after you’ve bought your lifetime annuity, so take some time to choose the one that’s right for you.
Check what your existing provider offers
Before shopping around, make sure you understand what your provider is offering you.
Check:
- Whether your provider offers a Guaranteed Annuity Rate. This is not the same as a guaranteed period. A guaranteed annuity rate means that the provider has to offer a minimum annuity rate for your pension fund. Now that annuity rates are a lot lower than in the past a guaranteed annuity rate can be valuable and could give a higher retirement income than can be bought on the open market;
- Whether your provider will charge your fund if you buy your annuity from another company. Your existing provider will usually give you a quote for a specific type of annuity. Make sure you get a quote for the type of annuity you want, not just the one the provider offers you.
How long have you got?
- Annuity quotes are usually valid for between 7 and 28 days.
- If you change your mind – you have the right to withdraw or cancel. If so, the provider will tell you how quickly you must act.
Shopping around for your annuity
1. Get an estimate of the value of your pension fund,
taking account of any charges, from your provider
2. Decide whether you want to take a tax-free lump sum,
and if so, how much (usually up to a quarter of the fund).
if you decide to take a tax-free lump sum, deduct it from the
pension fund value your pension provider gives you.
3. Decide whether you want:
a. A single or joint annuity. If joint life, whether the pension
paid to your partner is paid in full or reduced
(say by a third)
b. A level or escalating annuity.
4. Think about whether you want your annuity to continue to be
paid for a specific number of years (5 or 10), should you die
shortly after you buy it.
5. Does your fund need to be a certain size to qualify for the
better rates offered
by another company? Some firms may not be interested in
providing an annuity for small sums.
6. Are you a smoker? If you are, you may get a better rate from
some annuity providers.
7. Do you have a medical condition that could reduce
your life expectancy? If you do, you may get a better
rate from some annuity providers. Some providers
of impaired life annuities will also accept funds of
less than £5,000.
Protecting your annuity
There are two ways to protect your annuity:
You can opt for your annuity to pay out for a specific number of years, usually to cover the first five or ten years of income, even if you die within this time. On your death the income may continue to be paid for the rest of the guarantee period or it may be paid to your estate as a lump sum (and tax may be due on it).
You should not look at a guarantee as an alternative to a joint-life annuity, because any income will stop at the end of the guarantee period, not when your spouse or partner dies.
- Annuity protection lump sum death benefit
An annuity protection lump sum death benefit is another way of protecting your annuity if you die before age 75. A lump sum equivalent to the amount used to buy an annuity, less any income you have received, will be paid to your estate or beneficiaries on death. There will be a tax charge, and depending on the amount of money within the estate after the payment is made, there could be an inheritance tax charge. An annuity with a guarantee or an annuity with a lump sum death benefit will be more expensive than a conventional annuity, so the income you will get will be lower.
Other retirement options
All these options involve extra costs and extra investment risk compared with buying a lifetime annuity at retirement. They are not usually suitable if you have a small pension fund (after taking any lump sum) or you have no other assets or sources of income to fall back on.
Phased retirement
Phased retirement uses part of your fund to buy an annuity. The rest of your fund remains invested. You can later use another portion of your fund to buy another annuity. In this way you can provide a flexible income. Each time you convert part of your plan to an annuity, you can take part of it as a tax-free cash sum. Insurance companies often set a minimum fund size for annuity purchases.
Phased retirement is complicated and needs thought, planning and management. You'll probably need some specialist financial advice.
Unsecured pensions
If, for whatever reason, you decide that you're not ready to buy a lifetime annuity, you will have the option of an unsecured pension using either:
- Short-term annuities; or
- income withdrawal.
An unsecured pension means that after taking any tax-free cash, the remainder of your pension fund remains invested.
Short-term annuities
With short-term annuities, you can use part (or all) of your pension fund to buy a fixed-term annuity lasting up to five years. You choose your annuity options in much the same way as a basic lifetime annuity. In the meantime, the remainder of your fund continues to be invested. At the end of the fixed term you can buy another short-term annuity. You can also combine income from a short-term annuity with income withdrawal. However, you must take an income from your pension fund before your 75th birthday. Generally this is in the form of a lifetime annuity.
Income withdrawal
With income withdrawal, you can take a taxable income direct from your pension fund while the remainder remains invested. Income withdrawal is an option with most personal pensions and some occupational money purchase schemes. In some cases if you are in an employer's scheme and want to use income withdrawal, you must first transfer your pension rights from that scheme to a personal pension. You will probably be charged for this. Every five years your pension provider must review the amount of income you withdraw. This must be below the limit set by HM Revenue and Customs. Your pension provider calculates this. You can withdraw any amount from your fund as long as it's below this limit. There is no minimum amount of income that must be taken. However, you must take an income from your pension fund from your 75th birthday. Generally this is in the form of a lifetime annuity.
Alternatively secured pension
Before your 75th birthday you must secure an income from your pension funds, which generally means buying a lifetime annuity. A variant to this is an alternatively secured pension, which works in a similar way to an unsecured pension but has different rules. However, the government has indicated that alternatively secured pensions are only intended for a small group of people who have a religious objection to buying an annuity. You should take this into account when making a decision on how to secure your pension - an alternatively secured pension may not be suitable for you. Also, inheritance tax and other significant tax charges may apply to any left over funds on your death under this option.
All these options involve extra costs and extra investment risk compared with buying a lifetime annuity straight away. They are not usually suitable if you have a small pension fund (After taking any lump sum), or you have no other assets and sources of income to fall back on.
New options are now available which remove much of the investment risk but still may involve extra costs.
Hybrid products
An option if you don't want to commit yourself to a lifetime annuity but don’t want the investment risk of income withdrawal. These new products pay regular income and offer guarantees of either:
- investment growth; or
- the amount of pension fund you can expect to have left to buy an annuity later on.
These new products vary in what they're called, the guarantees they offer and the charges they make to cover the cost of the guarantees. You generally have to give up some investment growth potential to pay for the guarantees. It's a good idea to get professional advice on these and other retirement options
