What is a Pension Annuity?

By: Steve A Wright

When the investment in your personal pension plan reaches maturity when you retire, you will need to transfer its accumulated value into a regular income for the remainder of your retirement. This is achieved through the purchase of a pension annuity - a seemingly simple and straight forward transaction that exchanges the final value of the pension fund into which you have been paying into a regular income.

Whilst the principle of a pension annuity is seemingly very straight forward, however, things are rarely quite as simple as they seem.

The first and probably most critical aspect of buying a pension annuity is that it is a long-term, one-off commitment. You have just one shot at it, since there is no going back and asking for a refund of all of the capital simply because, after the event, you have found a better deal elsewhere. In other words, it is very important that you make the right choice.

Making the right choice is made no easier by the fact that a host of different annuities all offer a host of different annuity rates - i.e. will offer a different level of income for the same amount of pension investment.

The difficulty is further compounded by the sheer number of different types of annuity available these days.

Standard annuity - the most conventional form of annuity is one that pays you a fixed income throughout the remainder of your life. The income is known in advance, so you have the security and peace of mind in knowing just how much that will be;

With profits annuity - as the name suggests, this relates the income you receive to an element of your initially invested sum that is in turn invested again in equities, bonds and gilts. In this way, your annuity reflects some of the risks inherent in such investments;

Unit-linked annuity - this is probably the choice for those prepared to take the greatest risk on an annuity that is entirely subject to the fluctuations of the investments made;

Immediate ("temporary" or "purchased life") annuity - this form of annuity needs to be purchased either from the cash element of your matured pension fund or some other cash resource. The advantage of this kind of annuity is that part of the annuity is treated as a return of your initial capital and, therefore, is not taxed, whereas the whole of your pension annuity would be subject to income tax;

Impaired life annuity - this is a type of annuity designed for those whose actuarial life expectancy is lower than someone of the same age in the general population. Different annuities will operate different definitions of what amounts to "impairment" of life, but it is generally a question of an existing serious illness or lifestyle factors such as smoking, obesity or past occupation.

Summary

The seemingly simple and straight forward question of converting the final value of a pension fund into a regular, income-paying annuity actually requires the kind of advice you can best receive from an independent financial adviser, since:

•Your pension annuity decision is of a one-off type that you need to get right the first time;

•There is considerable variation in the level of income paid by any one annuity - naturally, you would want the highest paying;

•There is a wide range of different types of annuity - some higher, some lower, risk - an independent financial adviser will be able to help you choose the one you want.

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