This article focuses on Money Purchase Schemes – so, schemes where you save up a fund to buy your retirement income e.g. Personal Pensions, SIPPs, SSASs, Stakeholder Pensions, Defined Contribution Workplace Schemes
Key Points
- You do not have to accept the pension income offered by your pension scheme. You have the right to take your retirement income from a different provider – this is called the open-market option (OMO).
- Your scheme may not offer the best deal for your money when you retire, so check whether you can get more for your money by using the open-market option.
- In difficult economic times, your pension fund may be worth less than you expected, so getting the best deal is even more important.
- Choosing how to take your retirement income can be a complicated decision. I always recommend that you take professional advice from a suitably qualified Independent Financial Adviser authorised by the Financial Services Authority (FSA).
Making your retirement choices and always think before you choose
Things you should know :-
- Your pension scheme should send you, no later than 6 months before you are due to retire, details of the choices you have.
- This information will discuss buying an annuity (an arrangement which provides you with a pension income for the rest of your life).
- Your pension scheme must tell you that you have the right to shop around and about the different types of annuity that are available.
- You do not have to accept the annuity quoted by your pension scheme and you can shop around to find the best deal – this is called the open-market option.
Your income in retirement will depend on 4 main things:
- how much money you and your employer have paid into your scheme;
- how this money has been invested;
- how much of this money has been used to pay any charges; and
- the decision you make now on how you take your retirement income.
If your pension fund rises and drops in value (for example, all or some of it is linked to stocks and shares), you may want to consider switching your fund into a lower risk investment to reduce uncertainty in the run up to retirement. Check with your scheme whether this option is available and whether there is a charge for switching your money.
Making your retirement choices
You may get better value for your money if you shop around using your open-market option.
Before you make any decision, you need to consider:-
- your overall financial situation;
- what you might need financially in the future; and
- how much tax-free cash you want to take (i.e. a pension commencement lump sum).
There are limits on the amount of cash you can have as a lump sum – typically, up to 25% of your fund. The cash you take will affect how much money is left over to buy your pension income.
I would recommend that you take qualified financial advice
What is an annuity?
An annuity converts your pension savings into a series of payments – the pension scheme pays your pension savings to an insurance company who, in return, agrees to pay you a regular income for the rest of your life. This is often called a lifetime annuity.
What affects the cost of an annuity?
- Type of annuity
- Age – annuity rates tend to get higher the older you are
- Sex – annuities for women currently cost more. This is due to a change which will apply from December 2012.
- Health and lifestyle
- Prices vary from provider to provider just like any other goods or services you buy, which is why it is so important to consider shopping around.
How does the open-market option work?
You have a choice of who provides your retirement income when you retire. Your pension scheme will normally offer you an annuity but you can also shop around so you can choose the annuity that best suits your needs. Shopping around using your open-market option helps you to:
- find out how the cost might vary between providers;
- identify different features which may help you find the annuity which best suits your circumstances and how these features can affect the cost of the annuity or how much pension you get; and
- decide if you want to choose another option instead of buying an annuity if your scheme allows this.
- to find out if the annuity offered by your scheme is competitive;
- if you are in poor health as this may mean you can get a higher annuity; and
- if your lifestyle may qualify you for a higher annuity, for example, if you smoke or do a particular type of job.
Even if you have been very happy with your pension scheme up to now, consider the open-market option to check that it is offering the best deal for you when you come to retire.
What types of annuity are there?
There are 2 basic types of annuity – a single-life annuity and a joint-life annuity. There are other features that you could choose to include in the basic types, to suit your needs and circumstances. Check which features are included in the annuity offered by your scheme.
Single life – This pays an income to you for the rest of your life.
Joint life – This pays an income to you for the rest of your life. And then, when you die, it continues to be paid (possibly at a reduced rate) to your spouse or partner until they die.
Options you may be able to include:
Level – the pension income you receive stays the same throughout your life.
Yearly increases (escalation) – the pension income you receive increases each year, in line with inflation (the Retail Prices Index (RPI) or the Consumer Prices Index (CPI)), or at a fixed rate, for example, 3% or 5% each year.
Guarantee period – your pension income can be guaranteed for a set period, usually 5 or 10 years, so that it continues to be paid (usually to your widow, widower, civil partner, or to your estate) for the rest of the guarantee period if you die before the period ends. If you include a guarantee period, it may involve a small reduction in the amount of your annuity.
Lump sum on death – if you die, the annuity will pay out a taxable lump sum, equal to the cost of your annuity less any income you have already been paid.
Investment-linked annuities (including with-profit annuities) – these annuities offer the potential for you to receive a higher income but rely on stock-market performance. As a result, your income could go down as well as up.
Impaired life annuities – these annuities can pay a significantly higher income if you have a health problem that threatens to shorten your life. In cases of serious ill-health, where a registered medical practitioner confirms that your life expectancy is less than a year, the law may allow you to take the whole of your pension fund as a lump sum.
Enhanced life annuities – these annuities can pay a significantly higher income if your lifestyle may shorten your life.
What alternatives are there to an annuity?
When you retire, you may decide you do not want to buy an annuity.
Some of the alternatives we describe below may only be suitable if you have a large amount in pension savings or other sources of income and are comfortable taking some risk with your pension. Not every pension scheme offers all or any of these alternatives.
Again, before making a decision you should take qualified financial advice.
Make sure you are comfortable with the risks of choosing one of the alternatives to an annuity.
Cash lump sum – for smaller funds (this is sometimes called trivial commutation).
If you are at least 60, you may be able to take all your pension savings as a lump sum. You can usually only do this if the total value of all your savings in all pension schemes is less than £18,000. If your fund value in an occupational fund is less than £2,000 then you can take it as a cash lump sum if your scheme rules allow, even if all your pension savings are more than the minimum amount of £18,000.
You usually pay tax on part of these lump sums.
Phased retirement – you can use your pension savings to buy annuities at different ages in the future.
Drawdown pension (sometimes also called income withdrawal or drawdown) – you take an income directly from your pension fund.
Short-term annuities – you can buy a series of annuities each lasting for a fixed term (usually up to 5 years). You can then leave the rest of your savings invested or use them to buy a lifetime annuity.
Putting off buying an annuity
Your scheme rules may allow you to put off (postpone) buying an annuity, whether or not you stop working. By postponing buying an annuity (either for a limited time or indefinitely), you may get a higher annuity because your pension savings will have been invested for longer and you will be older. However, annuity rates and investments can go down as well as up. Check whether you may lose any guarantees or have to pay any charges by putting off taking your pension income. It may also be possible for you to be paid your tax-free lump sum but delay taking any income.
Other ways
There are new options now available which pay a regular income and offer protection and/or guarantees of either investment growth or the amount of pension fund you will have left to buy an annuity later on. They vary in:
- what they’re called;
- the guarantee/protection they offer; and
- the charges they make to cover the cost of the guarantee/protection.
You generally have to give up some investment growth potential to pay for the guarantee/protection.
What things should I keep in mind if I shop around?
- If you use your open-market option and decide to buy your annuity from another insurance company, your pension scheme might take charges from your fund. You need to get an estimate of the value of your fund (less any charges) before you can ask insurance companies for a quote for an annuity.
- Make sure you compare like with like. For example, don’t compare a level annuity with one that increases.
- Make sure any annuity you choose fits with your circumstances. (For example, do you need an escalating annuity or do you qualify for an enhanced annuity?)
- Check whether you will lose any benefits (for example, the option to buy an annuity at a guaranteed rate) or pay any charges if you don’t take up your pension scheme’s offer.
- Quotes for annuity rates are often available only for a limited time, usually seven to 28 days. Also find out if there is a ‘cooling-off’ period during which time you can cancel any choice you make.
- You may find it difficult to shop around if you have a small pension fund (less than £30,000) as some firms will not provide an annuity.
- Not all companies will deal with you direct and only offer products through financial advisers.
- If you use the open-market option, the adviser can be remunerated through a commission paid by the insurance company (you may prefer to pay via an agreed fee amount).
If you are comparing annuities under the open-market option, remember to compare like with like.
Frequently asked questions
What if I have a defined contribution fund in more than one pension scheme?
You may want to get financial advice. For example, you may be able to combine the money from all your schemes and use it to buy one annuity rather than buy a different annuity for each scheme. This may give you better buying power.
Do I have to pay tax on my pension income?
Yes, your pension income counts as earned income for tax purposes. Remember that most schemes will allow you to take a part of your fund, normally up to 25%, as a tax-free lump sum, as well as receiving an income.
What if I am contracted out of the additional State Pension (the State Second Pension)?
Your employer’s money purchase scheme will be able to tell you if it is contracted out of the State Second Pension (S2P). (This used to be called the State Earnings Related Pension Scheme (SERPS).) If so, you must currently use part of your pension fund to buy a ‘protected rights annuity’.
How will I know how much I have available to buy an annuity?
You can get an estimate of the value of your pension fund (less any charges for using the open-market option) from your pension scheme. Your pension scheme should send this to you before your retirement date, so you can start to shop around. You should then take off any amount you plan to take as a tax-free lump sum when you retire.
Will the stock market affect the value of my pension fund?
If you are invested in a fund which rises and falls in value (for example, it is invested in the stock market), the value can change. You may want to investigate whether you have the option to switch into a lower risk fund to reduce uncertainty in the run-up to retirement.
Who regulates annuities?
The Pensions Regulator, regulate workplace pension schemes. However, you will usually buy your annuity from an insurance company and these are regulated by the Financial Services Authority (FSA).
If an insurance company cannot pay all amounts due, the Financial Services Compensation Scheme (FSCS) may be able to help you.
Important Points to Consider
- Once you have bought an annuity, you cannot normally change your mind. So, it’s worth making sure you get the right one.
- In difficult economic times, your pension fund may be worth less than you expected.
- Take qualified advice as the implications can last a lifetime.
- If you want to delay taking your pension income, check for charges or penalties which might apply.
- Do you want to change funds before you retire?
- Do you want to take tax-free cash from your fund before you take an income? (Remember the Pension Commencement Lump Sum is only available at the date you take pension benefits and not afterwards – “a use it or lose it” benefit)
- What annuity options are available from your scheme?
- Compare what your scheme offers with the open-market option.
- Do you qualify for an impaired life or enhanced annuity?
- Would one of the alternatives to an annuity be suitable for you?
Where to get more information
You can get more information from the following organisations.
The Money Advice Service – also produce a range of free guides, available from its website.
Helpline: 0300 500 5000
Typetalk line: 18001 0300 500 5000
Website: http://www.moneyadviceservice.org.uk
Department for Work and Pensions (DWP)
Phone: 0845 606 0265
Textphone: 0800 731 7339
Website: http://www.direct.gov.uk
Financial Services Compensation Scheme (FSCS)
The FSCS helps protect consumers against financial loss when firms authorised by the FSA cannot or are unlikely to pay claims against them.
Phone: 0207 741 4100 or 0800 678 1100
Website: http://www.fscs.org.uk
The Pensions Advisory Service (TPAS)
TPAS is an independent organisation which can help with questions about your pension and annuities. You should also consider using the annuity planner on the TPAS website homepage.
Phone: 0845 601 2923
Email: enquiries@pensionsadvisoryservice.org.uk
Website: http://www.pensionsadvisoryservice.org.uk
The Pension Tracing Service
The Pension Tracing Service can help you track down pension schemes you have been a member of in the past. Their tracing service is free – you can either phone them and ask them for a tracing request form or you can use their online form.
Phone: 0845 600 2537
Textphone: 0845 300 0169
Website: http://www.direct.gov.uk
Your trustees or your scheme administrator
You’ll find their contact details in your scheme literature.
A suitably qualified independent financial adviser
So What is Secured Income?
This is the traditional route of Pension Annuities – there are more options available from permanent and temporary annuities but this is fund and age dependent.
