A fact about your annuity: Did you realise that annuities are probably one of the least popular and most misunderstood aspects of retirement among ordinary investors.

There is a small minority that don’t like annuities. If you die in the short-term, you get a bad deal. That is bad news, but that money cross-subsidises others. It is a strong system for supplying people with a guaranteed income.

For those set against annuities, income drawdown allows individuals to keep full investment control over their pension assets. Under drawdown, also known as unsecured pension, an individual can take an annual income between zero and 120% of a limit set by the Government Actuary’s Department, which is roughly comparable to the market annuity rate, from their pension fund.

If an individual using drawdown dies before the age of 75,  their pension benefits can be passed as a lump sum to their beneficiaries, less a 35% tax charge. Alternatively, their dependents can continue with drawdown or purchase an annuity.

Until 2006, anyone in drawdown had to purchase an annuity by the age of 75. Now, though, individuals over 75 can take an alternatively secured pension (ASP). Under ASP, the income limits are tighter than with drawdown and an overall tax charge of 82% applies to any remaining assets on death, making it a very unattractive as a way of passing on assets.

Some pension providers offer a facility called scheme pensions to individuals over 75. With scheme pensions, an actuary calculates the income that can be taken, taking into account an individual’s health, with the aim of exhausting the pension fund over the individual’s estimated remaining life.

This gives a higher income than ASP, particularly if life expectancy if poor. Similar tax charges to those under ASP will apply to any remaining assets on death.

For anyone considering drawdown and its post-75 variants as an alternative to annuity purchase, the risks involved should be fully understood. Many people see the choice at retirement as being a simple one between traditional lifetime annuities and income drawdown, but there are other options.

As well as conventional annuities, retirees could consider a temporary annuity for periods of five years upwards to a maximum of the time taken to reach age 75. Living Time chief executive Kim Lerche-Thomsen said that fixed term annuities allow retirees to ‘test-drive’ their retirement rather than making an irrevocable decision at a relatively early age.

Other alternatives to conventional annuities include investment-linked annuities and the so-called ‘third way’ annuity products. With investment-linked annuities, the annuity fund is investing in unit-linked assets or a with-profits fund. This means that there is an element of investment risk associated with the annuity. Prudential business development director Aston Goodey said there has been a resurgence of interest in with-profit annuities and noted, ‘They are a natural stepping stone from lifetime annuities and are middle to low risk.’

Third way annuity products, or variable annuities, from providers such as the Hartford, Met Life, Lincoln, and Aegon, seek to offer guarantees and more flexibility than a conventional annuity. 

For the many retirees with small pension pots, a conventional annuity may be the most sensible choice. For others, a combination of conventional and investment-linked annuities could give the foundation of a stable income with the chance of a rising income if the investment element does well.

For those determined not to annuitise, there is still income drawdown and its post-75 extensions. In this complex area, seeking good financial advice is wise. 

There appears to be a new offering out there. Cashback if you place your pension annuity; cashback from commission. But you have to choose exactly the pension annuity you want..no advice or support. Isn’t that a bit risky with something as important as a pension annuity purchase?

And, what happens to that cashback money? Surely it is taxable as income in the hands of the retiree and needs disclosing as such. Starting to look complicated? I think so, and you should think twice.

Getting the right annuity is crucial, because there is an awful lot to be lost by taking the wrong pension annuity at retirement. Failing to shop around and exercise the Open Market Option to purchase an enhanced annuity with the best rate is equivalent to losing 15 years of investment performance, according to leading annuity provider, Just Retirement.

Peter Ellis, head of annuities at Just Retirement, pointed out that a standard annuity as low as £4,900 per year could be bought with a fund of £77,130, according to the FSA tables (note…these rates do vary, this is only an example), whereas a fund of £56,518 could obtain an enhanced rate of slightly more - £4,934.

‘The benefit of selecting a good provider pre-retirement could be completely lost at the point of retirement. This is equivalent to throwing away 3.8% per year in extra performance - something nobody would be happy about,’ said Ellis.

The Open Market Option is available to most money purchase or individual pension funds and allows the policyholder to choose an annuity from any other provider. Increases in income of up to 11% could be obtained even for those in good health.

Enhanced annuities offer a higher income in retirement to those with certain medical or lifestyle conditions. More than 1,500 conditions could qualify for an enhanced annuity and in some cases; the income could be up to 40% higher than that from the original provider. Just Retirement estimates that up to 40% of people could receive a higher income at retirement thanks to enhanced or impaired annuities.

‘Selection of the best pension provider pre-retirement and an enhanced annuity at retirement could result in an increase of 73% in the final pension. At a time of grave concern about pension shortfalls, this highlights the value that can be added by advisers at all stages of the pension planning process,’ said Ellis. Other advisers should take note and remind clients of their ability to opt for the OMO and their potential eligibility for an enhanced annuity.

This is frightening, jaw-dropping. There’s so much money not being claimed under pension credit when annuities and other sources of pension income are inadequate.

A press release has recently been released by the Department for Work and Pensions detailing the take-up (or lack of) of the main means-tested and income-related benefits in Great Britain.  It’s a short, but shocking, read and contains such facts as the amount of unclaimed Pension Credit being somewhere between £1,960,000,000 and £2,810,000,000.  Think about that for a while. 

You know, all this talk of poverty in retirement isn’t as bad as it seems. Well, it wouldn’t be if people claimed what they are entitled to. Why leave all the money with the Government?

The UK annuity market has tripled in size in the last 15 years. It is the largest market in the world with nearly 300,000 new annuity contracts written in 2005 and premiums totalling around £8 billion. It is at the forefront of innovation. The ABI has set up the Retirement Income Group, made up of technical and marketing experts from its membership, which aims to strengthen industry thinking and practice on product innovation.

Over recent years there has been an increasing range of annuity products available which give individuals more choice. Most individuals traditionally purchased a standard flat-rate annuity, which pays out the same amount every month until they die. New types of annuity products have more features, and are tailored to meet specific lifestyle needs and tastes. 

Single-level annuities are the simplest type of annuity. They pay out exactly the same amount to an
individual (the “annuitant”) every month until the annuitant dies.

Guaranteed annuities pay out an annuity payment each month for at least the length of the guarantee
period, even if the annuitant dies before the end of the guarantee period; in which case the guaranteed
annuity payments are made into the annuitant’s estate. The maximum guarantee is ten years.

Inflation-linked annuities increase the annual payments by the rate of increase in the Retail Prices
Index (RPI) to give payments protection against inflation. Escalating annuities increase by say 3 or 5 per cent to give the pensioner some protection against inflation and to allow for possible increased income needs as the annuitant ages.

Joint-life or last-survivor annuities pay an agreed annuity payment to an annuitant and the annuitant’s partner while both are alive. Following the death of the annuitant the contract pays either the same amount or an agreed reduced amount each month until the partner dies. The reduction in last-survivor annuities is typically a half to one third.

Investment-linked annuities involve the fund backing the annuity being invested in an equity product.
The annuitant receives an annuity payment that is related to the performance of the equity market.

Impaired-life annuities pay an increased annuity payment if the annuitant has health problems, such
as cancer, chronic asthma, diabetes, heart attack, high blood pressure, kidney failure, multiple sclerosis or stroke.

Enhanced annuities pay a higher annuity payment related to actuarial considerations.

Phased-retirement or staggered-vesting annuities mean that instead of converting the whole pension fund, withdrawals are scheduled over several years. This is achieved by splitting the fund into many separate segments.

With-profits annuities link income directly to the performance of the insurance company’s withprofits
fund. Typically, income is made up of two parts: a minimum starting income and bonuses.

Short-term annuities allow an individual before 75 to use part of a pension fund to buy a fixed-term
annuity lasting up to five years. They can choose annuity options in much the same way as basic
annuities.

Value-protected annuities will pay a lump sum on the death of the annuitant, equivalent to the
difference between the original purchase price and total payments made. The lump sum is taxed at 35
per cent. They are only available until aged 75.

In recent years annuities have become available that support flexible or phased retirement. These offer the flexibility to change the level of income taken when moving from part-time to full retirement. Instead of converting the whole pension fund at once, withdrawals can be scheduled over several years which is achieved by splitting the fund into separate segments.

Investment-linked annuities (with-profits or unit-linked) can offer a monthly income together with another element that will vary depending on the investment performance of an underlying asset. These are attractive alternatives for those who want the opportunity for continued investment growth, but want to secure an income in retirement.

Current tax rules enable providers to offer consumers further choice in the way they flexibility can draw an income in the early stages of retirement. For example value protected annuities in the early stages of retirement return some capital in the event of death before 75. Providers can also now offer short-term annuities until 75. Whether or not these newer products become mainstream will depend on the extent to which consumers value these characteristics or providers choose to offer them.

There is also increasing interest in so-called “mid-market” type products, which “mid-market” combine elements of a guaranteed income for life with some control over how much additional income can be taken out each year and how the fund is invested. These features can potentially offer:
- peace of mind from a guaranteed income;
- the ability for consumers to secure returns related to their longevity experience
by entering a mortality pool;
- the ability for their fund to bear some investment risk; and
- the ability to vary the rate they can withdraw capital.

Whether such “mid-market” type products fall within the current pensions tax framework depends on the exact nature of the product being proposed. The current tax framework allows significant flexibility. The Government fully supports providers looking at new and innovative ways of providing income in retirement. Any new product, however, need to be consistent with the principle of turning retirement saving into a pension income for life.

Continuing innovation will be important in a changing market. The annuity market will continue to face challenges going forward.