What are the changes with pension annuities?
06 September 2017
Question by Keith
What are the changes with pension annuities? My mother in law has asked as her retirement is looming. I've read in the press it's changing but it all feels confusing. I just need some simple clear advice. Thanks
Answered by Boring Money
Annuities used to be the default pension product. You built up a pot of cash, swapped it for an income for life when you retired, job done. Even if you didn’t want to do this, it was tough luck, because the Government forced you to do it. This was designed to protect people doing something silly, like spending it all on inappropriate car or at the Bingo.
Annuities were OK. They stopped you running out of money, but there were some notable downsides. Once you’d bought your annuity, your capital pot was gone. So if you died early into your retirement, you had wasted all those years of saving. Equally, the level of income you receive from an annuity is linked to the income available on government bonds. This has fallen significantly as interest rates have fallen. This means you aren’t getting very much income in exchange for that pot of cash you have spent so long building.
Perhaps most importantly, the Government has changed its mind. It has finally decided that people can be trusted to act responsibly and has got rid of the compulsion to buy an annuity. This means that your mother-in-law can do exactly what she likes with the pot that she has built up over the years, including spending it at the Bingo if that’s her thing. In theory, she could take it all in cash and spend it how she sees fit.
However, there are a few things to remember: First, there will be tax consequences to whatever she does. The first 25% withdrawn from a pension pot is tax-free. Thereafter it is subject to tax at her marginal rate (i.e. the top rate of tax she pays on all her other income).
She will also need something to live on. She will still have bills to pay and therefore needs to find a way to generate an income. In this, an annuity may still have a place. She could use part of her pot to buy an annuity to ensure that she has enough to pay her basic household expenses.
The main alternative to an annuity is a drawdown portfolio. The advantage of this option is that the money from your pot remains invested, and can – theoretically – continue to grow. It also means that she will have something to pass on after she dies. In a drawdown portfolio, there is lots of flexibility about where she invests, but usually people build a portfolio of shares, corporate bonds and other assets such as property. Selected correctly, all these assets can pay an income.
One thing I would say here is that it is really, really important to get this right. She needs to pick the right blend of annuity/drawdown/tax free cash and to invest it prudently to ensure it’s going to last her a lifetime. Of all the times in her life when it could be worth paying for some one-off financial planning, this is it. A session with a financial adviser can ensure that she structures it all correctly. Check out www.unbiased.co.uk.