The fund from a money purchase scheme can be used to buy a lifetime annuity on vesting. Up to 25% of the fund (or possibly more, where there is a protected PCLS) can be paid out, as a tax-free lump sum and the remainder will secure a pension income through an annuity.
The annuity can be level, escalating or linked to a particular index. Flexibility in the escalation will be allowed, such as a one-off increase, rather than annual ones, to boost income in the event of ill health for example. The greater the inbuilt increases the more expensive they are to provide, and consequently the lower the starting level of the payments. It can take many years for the overall income received from a 3% escalating pension to equal that of a level annuity.
It is also possible for a surviving spouse, partner or financial dependant to continue to receive an income at a level agreed at the commencement of the annuity. The level is a percentage of the annuity, normally 100%, 66% or 50% and will continue for their lifetime. The annuity can have a guarantee of up to 10 years or could be a “value protected” annuity (see below).
One concern that many people have with annuities is that should they die shortly after purchasing their annuity, the amount of income paid out could be significantly less than the purchase price. “Annuity Protection” helps address these concerns by allowing a lump sum to be paid in the event of death.
The maximum lump sum payable is the initial purchase price, less the sum of the income paid, or to be paid under any guarantee period selected. The amount of protection can range up to a maximum of 100% of the purchase price. This allows for all or part of the initial purchase price to be protected and accordingly this additional feature must be selected at outset as it cannot be added later.
The following illustrates how annuity protection works (example only):
Purchase price £100,000: Single life income £10,000 p.a. with no guarantee period
The lump sum payable for 100% and 50% annuity protection on death after two years of income is paid, is as follows:
With 100% annuity protection: (£100,000 X 100%) less (2 x £10,000) = £80,000
With 50% annuity protection: (£100,000 X 50%) less (2 x £10,000) = £30,000
Any annuity protection lump sum payable will be paid net of tax, currently at a rate of 55%. From an Inheritance Tax perspective the payment should not fall within the annuitant’s estate for Inheritance Tax purposes.
There are both advantages and disadvantages in respect of purchasing a lifetime annuity which are summarised below:
Advantages of Lifetime Annuity Purchase
- Buying an annuity is straightforward, with minimum paperwork, and no ongoing reviews.
- You receive a fixed or increasing income for life, which should not fall in value (except against inflation).
- You have no exposure to investment risk and can receive all of your tax-free cash lump sum at the start.
- Your pension can be guaranteed, in any event, for up to a maximum period of 10 years and a return on death is now available under value protected annuities.
- The benefit of mortality gain; those who live benefit from a cross subsidy from those who die. An allowance for this is built into the annuity rates offered by the provider.
- You may exceed your life expectancy and ‘profit’ from your annuity.
Disadvantages of Lifetime Annuity Purchase
Although annuity payments are guaranteed, there are risks associated with the purchase of an annuity. A number of these risks are detailed below:
- Annuity rates are relatively low in relation to historical rates and there seems little likelihood of them improving by any significant amount in the near future.
- Annuity rates generally increase with age but are fixed once they have been purchased (apart from the regular increases which can be built into the annuity).
- Unless annuity protection is included when you purchase an annuity then the fund is spent. If you die in the early years there may be some part of the guarantee period remaining so that the future instalments would be payable to your estate.
- Your pension options are fixed at outset and cannot be altered to take account of changes in personal circumstances such as becoming a widow or widower.
- Your pension cannot be altered in value to take account of fluctuations in supplementary sources of income.
- Selecting an increasing annuity to help cope with inflation substantially reduces the initial payment level.