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Buying an Annuity
Pensions Beginners Page
Welcome to the fourth in a series of articles designed to introduce readers to some pensions' related topics.
Buying an Annuity
There are many types of annuity and reasons why they are set up. This article is specific to retirement annuities purchased from an approved defined contribution (DC) occupational pension scheme.
At the time the member chooses to draw benefits, "retirement", an amount from the DC scheme will be available to provide retirement benefits. This is made up of contributions and tax relief and reflects the investment performance net of any charges over the period of membership. The member normally has the option of taking some of the fund in the form of a tax free cash payment before leaving the remainder to provide retirement income which is typically arranged by the purchase of an annuity. As such, the annuity will be the pension income element of the retirement benefits.
The type of annuity to be purchased will be a compulsory purchase immediate annuity (CPIA). That is to say, the annuity must be purchased as a condition of the pension scheme and that the annuity comes into payment immediately.
The pension scheme will be a type of trust and, as such, the trustees will have ownership and powers over the money invested on behalf of the member. So it will be the trustees who decide the exact details of the annuity and purchase it for the benefit of the member. Annuity business is regulated by the Financial Services Authority so only approved companies can provide annuities.
There will be some conditions governing the detail of the annuity. For example, the pension must be paid for the remainder of the member's lifetime and there may be some conditions regarding some or all of the following:-
- Annual increases
- A pension for a dependant spouse
- Guaranteed payment period in the event of the member's death
- Overlap between the spouse's pension & guarantee period
Annual increases
The annuity, or elements of it, may remain level throughout the annuitant's (and spouse's) lifetime, or may increase annually by a fixed rate or change in line with an index such as the RPI.
The increase may be on a fixed date or on the anniversary of the first payment of the annuity. In the case of the former it may or may not be a proportional increase.
Spouse's pension
Part of the purchase price may be required to purchase benefits for a spouse, either at the option of the member, as a legislative requirement or to comply with the scheme rules. The annuity policy may specify whether this is a 'named spouse' or 'any spouse'
Named spouse:- This means that the spouse's pensions is payable to the member's spouse at the time the annuity commences.
Any spouse:- The spouse's pension is payable to the member's spouse at the date of death. This might be different from the spouse at the commencement of the annuity.
Guarantee period
If a guarantee period is elected this may be classed as undiscounted, discounted or with continuing payments. Guarantee periods are typically 5 years.
Undiscounted:- Should the member die within the guarantee period the remaining instalments are payable as a lump sum. The lump sum reflects the remaining instalments.
Discounted:- Should the member die within the guarantee period the remaining instalments are payable as a lump sum. The lump sum will be reduced to reflect the early payment which is being made.
Continuing Payments:- On death the remaining instalments continue to be paid on the due dates until the end of the guarantee period.
Overlap
If there is a spouse's benefit, the benefit may be with overlap or without overlap.
With overlap:- The spouse's pension will commence immediately after the member's death and be payable in addition to any "guaranteed period" payment;
Without overlap:- The spouse's pension will commence at the end of the guarantee period.
Of course, the trustees will want to get the best value for money with the funds available and may seek financial advice in order to make their decision.
There are several annuity providers willing to provide better annuity rates for smokers and people in ill health or people living in certain areas.
The appointed adviser will not only research the annuity market for the best rates but will also take a view on the long term financial stability of the prospective provider. Other factors such as quality of service may also come into play. The adviser will have to declare to the trustees whether they are receiving commission from the provider for placing the business with them.
Once the annuity has been purchased, the annuity policy will remain the property of the trustees until such time as the guarantee period (if any) has expired. At this point any benefits payable under the trustees' discretionary powers will have expired and the policy can be assigned to the member.
Purchasing an annuity is a specialised service and can be literally a once in a lifetime opportunity. Making the right choice is imperative to obtain the best value for money and ensuring financial security for the pensioner and their dependants.
Carole Ward & Chris Potts, November 2005.