Annuities

Why do I need one?

If your pension is held in a Personal Pension (or Stakeholder scheme), some types of  occupational DC scheme or a money purchase AVC then some or all of your pension must be used to purchase an annuity by law. This type of annuity is called a Compulsory Purchase Annuity and is discussed below. If you are in a Personal Pension scheme then around 25% (the Protected Rights element of your fund cannot be taken as cash) of your fund can be taken as tax free cash and the remainder must be used to provide an annuity. If you are in an occupational DC scheme the amount of cash you can take will be broadly similar but dependent upon the scheme in question and way it is set up with the Inland Revenue. If you have an AVC policy and you started it after 1987 then it will all have to used to purchase an annuity.

There is much in the press of late about the requirement to purchase an annuity at retirement. Some people think it is a too onerous restriction to place on pension savers and that the restriction should be abolished. The main reason for this is that the current terms for purchasing annuities are considered poor value. However what are the current options?

Lets consider your options if you do not buy an annuity (and remember you do not have this choice for much of your pension fund anyhow!). You could just slowly eat away at your pension fund year on year to provide you with an income. Sounds like a pretty sensible idea and this would also permit you to leave some capital for your dependents. However how much are you going to take each year?

If you take too much then you will run out of pension and face an impoverished old age living off whatever state benefits you are entitled to. If you take too little then you will not have felt the benefit of all those years of saving for your pension. What you need to know is exactly how long you will live and then you can take just the right amount to leave you will a zero pension fund on death. Unfortunately (or maybe fortunately) none of us can know this with any certainty.

However an insurance company can pool everyone's risks and give people incomes based on their average life expectancy. This way everyone gets an income guaranteed for the rest of their life. If people die soon after taking an annuity then the capital the life insurer has saved can be used to pay out the pensions for those who live considerably longer than normal. The insurer has lots of annuities and so can balance the books by some people dying before their average life expectancy and others after.

An annuity is insurance against living longer than your funds would permit you to live comfortably. The price you have to pay for this peace of mind is knowing that if you die before your average life expectancy then you will not get back the unused capital.

Annuities are life insurance contracts, just in reverse. Therefore annuities are sold by life insurers as they hold the expertise needed to assess how long they expect people to live on average.