21st February 2014
The vast majority of people who buy an annuity from their existing pension provider would be better off if they shopped around according to in-depth research of the market by the financial watchdog writes Plan Money founder Peter Chadborn.
The Financial Conduct Authority’s recently published its thematic review of the annuity market was reported on Mindful Money on February 21st this year.
Those of us who give financial advice in this area have been saying for years that pension companies need to be clearer when communicating to their clients who are retiring to help them fully understand the options. We have argued that they need to promote the fact that you can shop around to see if more favourable terms can be obtained in the annuity market otherwise known as taking the Open Market Option.
All of the headlines have been about uncompetitive annuity rates but this is only half the story, in fact not even half the story. Anyone considering buying an annuity should first decide how the annuity needs to be structured. Arguably, getting this wrong will have a greater detrimental effect than an uncompetitive annuity rate.
Some of the key aspects to assess are:
1. Your health – if you are a smoker and/or have some health issues you may be eligible for an ‘impaired-life annuity’, with an enhanced annuity rate.
2. Your Age – the older you are the higher the potential income rate you will receive, due to shorter life expectancy. Also, a population with increasing life expectancy has a downward pressure on annuity rates.
3. The Cost of delay – by waiting to try to gain a higher annuity income in the future, you must not forget to take into account the income you will miss out on during the delay. It is important to understand where the break-even point is. In other words; how long it will be before the increased annuity achieved by delaying equals the ‘lost income’ whilst deferring.
4. Indexation – this feature means the income would increase annually at a set percentage or by the Retail Prices Index. However, the initial income is considerably lower. Similarly to the Cost of Delay issues, it is important to understand where the break-even point is. In other words; how long it will be before the reduced index-linked annuity catches up to the level annuity. Furthermore, how many years of income are required after the break-even point before the cumulative (initially lower) increasing income equals the cumulative level income.
5. Spouse’s benefit – this benefit means that a proportion of the annuity income would continue to be paid to your spouse in the event of your death. Again, the initial income received is lower to allow for this benefit. This decision should be driven by the degree to which your spouse would be financially secure in the event of your death. In other words; if they are independently secure in terms of retirement income or have sufficient capital to provide financial security, this benefit is not essential.
Of course if your spouse predeceases you, you would be receiving a lower income for a benefit which is never going to be realised, therefore your spouse’s health and general life expectancy is a factor for consideration.
6. Guarantees – most pension annuities will automatically be guaranteed for 5 years. This benefit means that there is a minimum term of 5 years, regardless of when death occurs, for which the annuity would be paid. You have the option of extending the guarantee term to 10 years.
7. Current scheme guarantees – it is vital to check whether your current pension provides any guarantees, such as a guaranteed annuity rate.
8. Tax free cash – you annuity will be taxed as income but have the option to take up to 25% of your fund as a tax free lump sum. However, there are times when taking the tax free cash is not advised, such as; if the current scheme has a high guaranteed annuity rate in other words you could be diminishing a very valuable long term benefit by taking the cash.
9. Other options Of course for some people a conventional annuity might not even be right and maybe they should consider the merits of investment-linked annuities or pension drawdown. What is without doubt is that an annuity purchase is unlike most financial planning decisions in that it is irreversible so it is vital you get it right