Shopping around for the best deal pays dividends
Since the purchase of an annuity is a one off transaction, it is vital that you not only select the most appropriate benefits, but also shop around for the best deal for your money. Although under the Open Market Option (OMO), an individual is not required to purchase an annuity from the provider with whom they made their pension savings, in reality relatively few take advantage of the opportunity to switch.
Statistics suggest that the number of annuitants that exercise the OMO has remained at just above the 30% mark, despite ongoing efforts to raise awareness of the potential benefits to be gained. For instance, for a standard level without guarantee annuity, research shows that a male aged 70 could be almost 10% better off by selecting the best rate available.
Back to basics
An annuity is essentially a guaranteed income for life paid by an insurance company in exchange for a lump sum payment. There are two main groups of annuities: compulsory purchase annuities (pension annuities) and purchased life annuities.
Compulsory purchase annuities represent by far the biggest market and are bought with the proceeds of an employers' pension scheme or personal pension. Under the current rules, an individual can annuitise their pension pot at any time between the ages of 50 and 75. Compulsory purchase annuities are taxed as earned income and are usually paid net of basic rate tax. If you are a higher rate taxpayer you are liable for additional tax.
A purchased life annuity can be bought voluntarily from an individual's own capital. Although it does not originate from a pension fund, a purchased life annuity is typically used to supplement retirement income or to meet the expense of nursing home fees. One of the key attractions with a purchased life annuity is that part of each payment is regarded as a return of capital and is tax-free. Tax is deducted from the interest element only.
Level of income
Regardless of whether you are considering a compulsory purchase annuity or a purchased life annuity, the level of income paid will be determined by the same factors. These not only include the size of the premium, the age, sex and health of the individual, but also the annuity payment options chosen. Generally speaking, the more options added the lower the income will be.
So what are the most important payment options and benefits that a potential annuitant will need to weigh up?
Single or joint life Individuals looking to ensure that their spouse or partner continues to receive an annuity income after they die should consider a joint life annuity. On the death of the first life, the income passes to the spouse or partner for the rest of their life. This income can also be paid on a reduced basis such as two thirds or half the original amount.
Level or escalating. A level annuity is the simplest and most common choice and will provide the same income each year for the rest of your life. Although a level annuity has a higher starting income than an escalating annuity, its purchasing power will ultimately reduce as prices rise. To protect against the scourge of inflation, an escalating annuity can be selected, with increases set at a fixed rate each year such as 3% or 5%. Alternatively the income can be linked to the Retail Prices Index (RPI).
With or without guarantee: you can choose the option of adding a guarantee for up to a maximum of 10 years. This will ensure that on death the annuity income will continue to be paid to an individual's estate until the end of the specified guaranteed period.
Enhanced and impaired life annuities
For consumers who have either lifestyle or health considerations, opting for an enhanced or impaired life annuity could provide a further income boost of up to 30%. Enhanced and impaired life annuities can be divided into three categories: smoker rates, enhanced rates (underwritten on the basis of completed application form often using a computerised system) and impaired life rates (requiring individual medical underwriting including submission of a medical report).
Going forward
The number of people who will need to buy an annuity to provide an income for life is forecast to rise steeply over the coming years. While average amounts to be annuitised remain relatively low, the priority will be to maximise the amount of income received by shopping around to obtain the best price for their annuity.
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