Why you need to think carefully about an annuity
With recent research showing "pre-retirees" are financially worse of than those already retired and confusion over what annuities are, Kate Saines investigates this complex financial product to explain why we all need to think about them more carefully.
According to a recent study, people aged 55 to 64 are much worse off financially than those in the older generations.
Apparently, 40% of this age group do not save any of their money and one fifth owe more than £75,000 on their mortgage.
And, to make matters worse, many of this group dubbed the 'pre-retirees' could be "jeopardising their retirement though a worrying level of ignorance about annuities".
That is according to the Real Retirement Report published by Aviva, which presents a worrying outlook for the retirement prospects of the over-55s.
This is a generation, says Aviva, which apparently does not take out joint annuities, is unaware of what affects annuity payouts and does not understand they derive an income from one.
Darren Dicks, head of annuity propositions at Aviva Life, says many find retirement planning confusing.
And despite the fact legislation has made it compulsory to purchase an annuity before the age of 75, few over-55s know about them.
He says: "This lack of knowledge could see some people settling for a far lower income than they are entitled to or others finding that their income dries up altogether when their partner dies.
"The type of annuity a person chooses can impact on their standard of living for more than 30 years so it is vital that they understand as much as they can about these products before making a choice.
"A little knowledge could really make a difference and increase a person's retirement income by up to ten per cent."
It is a view echoed by many. Both charities and pension industry insiders have called for greater education of the options available.
Pension provider, Just Retirement, has been campaigning to create a better understanding of annuities and of consumers' right to "shop around" for their annuity for some time.
It is also keen for the industry to break away from using jargon and technical terminology which can put people off.
This is all very well, but there appears to be little out there at the moment to help pre-retirees navigate their way through the annuities maze.
But where is the best place to start? Since Aviva's research suggests few people know what an annuity is.
Just Retirement explains that it is a product which converts a cash sum into a long-term guaranteed income of a known amount. The cash sum, if you have been making pension contributions, will usually be your pension fund.
When you are approaching retirement an annuity provider will look at your fund and calculate how much income can be paid to you for the rest of your life.
You can receive this income monthly, quarterly or annually and it will be taxed in the same way as earnings.
According to Nigel Barlow, head of research at Just Retirement: "The rate that is set at the start of your annuity is dependent upon a number of factors - the size of your fund, the benefits you select, such as any minimum guaranteed payment period, your spouse's pension or escalation rate."
Opting for an escalation rate means your income will increase each year. Choosing this could affect annuity payouts because the figure will be lower, initially, than a level income.
Mr Barlow says life expectancy also plays a role in deciding your payout. There are also commission payments and various expenses and charges.
So what can you expect to receive from your annuity? According to Just Retirement, a male aged 65 with a £100,000 fund could purchase a level income of £7,100 per year if they were healthy. Or they could purchase an income of £8,100 if they have medical conditions.
The same man could purchase an escalating income starting at £4,500 if they are healthy to £5,400 with medical conditions, which would rise in line with inflation.
A female with the same fund could purchase a level income of £6,070, if she were healthy, to £6,880 with medical conditions.
Mr Barlow says: "Women tend to receive lower payments because not only do they retire earlier but they have higher life expectancies."
In other words, their pension fund is being stretched over a longer period of time.
Likewise, people with medical conditions will receive a higher income because - in theory - they are unlikely to live as long.
These rates are only examples and, of course, can vary greatly. If your pension provider offers you an annuity payout rate which you are not happy with you are more than within your rights to shop around elsewhere for a better deal.
Taking this route is known as using the Open Market Option. Nigel Barlow reckons a healthy man or woman could increase their income by ten per cent by shopping around. Someone with medical conditions could boost their payouts by 30% or more.
If you are putting money into an occupational money purchase scheme, you can also use the open market option.
And you don't have to stick with plain old annuities either. There is a growing - albeit slowly - market for other products to help you gain an income from your pension pot.
Instead of a fixed or escalating annuity, for example, you can buy an investment-linked, with-profits or flexible annuity which will enable you to benefit from underlying investment funds.
An unsecured pension, meanwhile, provides you with the option to leave your fund invested. That way you can tailor your income to your needs.
Nigel Barlow warns people to be cautious about taking this option, however. He says: "There is some risk to income if your fund does not perform as well as expected and this option is only suitable for those with larger funds."
Aviva's report also raises fears the over-55s are failing to take out joint life annuities and this could be jeopardising their retirement income.
A joint life annuity provides an income to a spouse or dependant in the event of your death. So, if you don't take this option and you die before your annuity has reached its term, your family will not benefit from the full payout.
However, Mr Barlow thinks many people are not choosing joint life annuities because they don't pay as much income as single life versions.
"If a client is married we would recommend they take at look at joint life annuities," he says. "But providing for a spouse will cut the pension you receive in your life."
It means this option does not always look as attractive on paper, but this does not necessarily mean you are maximising the potential benefits.
Just Retirement also suggests - as another way of obtaining the maximum possible income from your annuity - to declare all information about your medical history and any treatment you are receiving, including prescription drugs.
There is much to be done in the pension world to improve annuities. It is not only the lack of understanding around them that appears to be the problem.
Help the Aged and Age Concern are worried that people with modest pension pots are getting a poor deal from annuities because the tax penalties are too burdensome.
What is more the recession has caused many pension funds to fall in value and tumbling interest rates have hit annuity rates.
But the charities believe that with government help to find alternatives for those with small pension pots and better access to financial advice for all retirees who need it, the situation could be improved.
Some annuities terms you might hear and what they mean.
Guarantee - your annuity can be guaranteed to be paid for a specific period of time, up to ten years, even if you die before then.
Escalation - when your annuity payout increases each year. If you choose this option you can receive the increase as a fixed rate or in line with the Retail Prices Index (RPI).
In advance/arrears - if you annuity income is paid at the beginning of a period - each month, for example - it is paid in advance. If it is paid at the end of that period, it is in arrears.
Enhanced annuity - this takes into consideration any medical or lifestyle conditions you have, such as being a smoker, to allow you to receive a high income. Also known as impaired life annuities or underwritten annuities.
Overlap - if you have a spouse's pension and a guarantee period, the spouse pension can be paid from the date of your death while a guarantee is also being paid. This is known as overlap. If the spouse's pension is paid from the end of the guarantee period, this is without an overlap.
Value Protection - an option to have the difference between the amount you paid for the annuity and the total income paid to the date of your death paid to your estate. This in the event that you die before your 75th birthday. It is taxed at 35%.
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