Taking An Income From Your Pension
What options do I have?
When the time comes to take benefits from your pension (excluding final salary) you have three options:
- Swap your pension fund for an income for life, bu y buying an annuity
- Leave your pension invested and draw an income, known as flexi-access income drawdown
- Leave your pension invested and take one or more lump sums, known as an 'uncrystallsied funds pension lump sum' (UFPLS)
| Pension Income Options |
| Age |
Options |
| Under 55 |
None, unless ill |
| 55+ |
Annuity, income drawdown or UFPLS |
Let's look at each in turn.
Annuities
An annuity is a financial product sold by insurance companies. In return for giving them some cash they'll give you an income for as long as you live.
It's basically a gamble, if you live longer than expected you'll profit, if you die sooner than expected the insurance company is quid's in (or can at least compensate for
someone living longer than expected). When you use money from your pension fund you have to buy a 'compulsory purchase' annuity.
It's no surprise that the amount of annuity income insurers will give you falls (i.e. the annuity becomes more expensive) the younger you are, because they expect to be
paying you an income for longer. One of your biggest decisions is therefore at what age to retire and buy an annuity, too soon and you might not get enough retirement income,
too late and you could lose out.
Your other big decisions are which options to include in your annuity and which company to buy it from.
What age should I buy an annuity?
Unless you have an alternative source of income it's likely to be the age at which you stop working and retire.
However, if you can afford to delay or wish to carry on working you'll have a dilemma. Delay buying your annuity and the rate you receive could improve (because you'll be
older) and your pension fund could grow too. However, you'll be losing out on income meanwhile, which might more than offset the benefits. Annuity rates in general may also
change over time, for better or worse, largely depending on how much it costs insurers to build them (affected by the cost of gilts) and average life expectancies.
Mrs Haste retires at 60 and buys a single life level annuity with her £100,000 pension fund, providing an income of nearly £7,000 a year. Had she delayed until 65 let's assume the growth in
her pension fund and and higher annuity rate mean she'll receive an annual income of nearly £10,000. However, thanks to the income she's already received it would have taken
Mrs Haste until around age 79 for the total income received via the delayed pension to exceed that of the pension taken at 60.
But, as you get older the annuity rate may not increase by as much as you'd expect, due to 'mortality drag'.
If you delay buying an annuity you'd expect the rate you get to increase (ignoring interest rate movements etc). This is probably true, but it might not increase
by as much as you'd expect for two reasons (let's assume you delay buying from age 60 to 65):
- If you'd bought at 60 you would have benefitted from a 'cross-subsidy' (via higher overall annuity rates) from those that die before the average age assumed by the insurer.
Delaying to 65 means you'll lose out on some of this because some of the policyholders included in the overall calculation at 60 will have died.
- If you live to 65 the age at which you're expected to die is, on average, higher than it was at 60.
The upshot is that annuity rates don't generally increase with age by as much as you'd expect, the shortfall being caused by mortality drag. Or, putting it another way,
if you delay buying an annuity then your pension fund may have to grow by more than expected if you don't want your annuity purchasing power to fall.
Might you be better off taking now or delaying? Find out using our Pension Delay Calculator.
Annuity options
The most straightforward type of annuity pays you a fixed level of income until you die, at which point it ends. However, you can use a range of options to make the
annuity more flexible and attractive. For example, you could provide an income for your spouse when you die or ensure your income rises with inflation each year. Bolting on
annuity options will likely reduce your income (at least initially) but could prove invaluable if used wisely.
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A joint life annuity means your spouse, if still alive, will continue to get an income following your death. You can choose for them to receive any percentage of your
income, 100%, 67% and 50% are common, although the cost increases with the percentage. Figures vary, but expect to get around 10-20% less income yourself if you choose a
joint life annuity rather than one based just on your your life.
You can choose a period, usually 5 or 10 years, that your annuity is guaranteed to be paid for if you die meanwhile. The payments would normally be made to your
surviving spouse or another dependant. If you have a joint annuity the spouse's pension normally only kicks in after the guarantee has finished, unless you choose otherwise
(which makes the annuity more expensive). Some insurers allow the remaining payments to be paid out as a single lump sum, less a 35% tax charge.
Some insurers also offer 'value protection'. You choose the amount of your fund you wish to protect and if you die before 75 the chosen value is paid out as a lump sum,
less income payments already made and a tax charge, currently 35%.
If you opt for a level annuity pension, your income will be fixed for life. This means it will gradually buy less and less as the cost of living rises due to inflation.
If you have a level pension income of £10,000 and annual inflation is 2%, your income would buy just £8,171 worth of goods and services after 10 years and £6,676 after 20 (in today's terms).
You can protect the purchasing power of your annuity income by linking it to inflation (called 'index-linked'), so that your income increases each year by the Retail
Price Index (RPI). Or you could choose for your income to increase by a fixed amount each year. However, both of these options can be costly, so don't be surprised if it
reduces your initial income by 40% or more compared to a level annuity.
Find out whether a level or index-linked annuity might offer better value for you using our
Level versus Index-Linked Annuity Calculator.
If an insurer expects your lifespan to be shorter than average due to illness, they'll usually offer you a better annuity rate to reflect this (called an 'impaired life'
annuity).
If you're a smoker or overweight you might also receive a better rate than normal (an 'enhanced' annuity), for similar reasons. The rate for smokers could be 20% or more
higher than that for non-smokers.
How often do you want the income paid? Monthly, quarterly or annually? Choose the option that best suits your needs.
You can have income paid at the beginning of your selected period or the end. If the beginning, you should expect to receive a slightly lower income compared to the end.
Although quite rare, you can link your annuity income to investment performance (via a 'with-profits' or 'unit-linked' fund). Charges are likely to be higher than a
standard annuity and this approach means taking risk, so it's hard to find a sensible reason for buying one.
Be warned that these annuities usually pay salesmen and advisers more commission than a standard annuity, giving the less scrupulous ones an incentive push this option.
What affects annuity rates?
Aside from the various options detailed above and life expectancies, the biggest factor affecting annuity rates is the price of gilts (which, in turn, is affected by
interest rates and/or inflation). This is because insurers usually buy gilts (and/or high quality corporate bonds) to ensure they can pay the annuity income they've promised you
(index-linked gilts in the case of inflation-linked annuities).
Rising interest rates and/or inflation tends to reduce the price of gilts, which is good news for annuity rates (and vice versa when interest rates/inflation falls).
Drawing an income - flexi-access income drawdown
Instead of buying an annuity you can leave your pension fund invested (after taking tax-free cash if you wish) and then draw an income, called flexi-access income drawdown.
There is no limit on how much income you take and there is no requirement to take any income at all (i.e. yuou could just take the tax-free cash). This provides a lot of flexibility,but there are pitfalls.
| Pros |
Cons |
- You can draw income while delaying annuity purchase if rates are unfavourable.
- You can take up to 25% tax-free cash immediately even if you don't want to start drawing income.
- You can vary income to suit your needs.
- Decent fund growth could leave you better off than buying an annuity.
- It gives potential to leave some or all of your pension fund to your spouse or other beneficiaries when you die.
|
- Long term income is dependent on investment performance, so there's a risk. Your pension could even run out of money before you die.
- Your existing pension may not offer income drawdown, in which case you'll need to transfer to a pension that does (which could involve costs).
- You may want to get advice, which will cost.
- Poor fund performance could leave you worse off than buying an annuity.
- You'll suffer from 'mortality drag'.
|
If you opt for this route, a key consideration is to regularly review both your investments and the amount of income drawn to ensure you don't risk running your pension dry during your lifetime.
Taking your pension as a lump sum (UFPLS)
Many pension providers offer the option to take your pension as a lump sum. As usual, the 25% of the sum is normally tax-free but the balance is taxable. Therefore, if you take a large pension in this way
you might end up with a big tax bill if the 75% of the pension that is taxable falls within your basic, higher or top rate tax bands. One option, if income drawdown is not available, might be to take
a series of smaller UFPLS payments over several years if the pension provider allows this.
This route is only likely to be of interest where a provider does not offer drawdown or you have a small pension fund you wish to withdraw as cash in its entirety.
Pension Annuity Jargon
Here's some of the more common pension annuity jargon you might come across:
| Compulsory Purchase Annuity | The annuity you must purchase with your pension fund by age 75. |
| Deferred annuity | An annuity that starts paying an income for life in future, not straight away. |
| Guarantee Period | If an owner dies soon after buying an annuity, income continues to be paid for the duration of the guarantee period, e.g. 5 years. |
| Impaired Life Annuity | Pays a higher income than usual because the owner has a shorter than average life expectancy, e.g. smokers or those with a history of illness. |
| Income Drawdown | Rules by which you can draw an income from your pension rather than buy annuity. |
| Index-Linked Annuity | Pays an income for life which increases each year with inflation. |
| Investment-Linked Annuity | Pays an income for life, the exact level depending on the performance of a particular investment. |
| Joint Life | A pension annuity that continues paying an income (to a spouse or depenents) when the pension owner dies. |
| Level Annuity | Pays a fixed income for life. |
| Open Market Option | The right to shop around for the best deal on a pension annuity, you're not obliged to buy from your pension provider. |
| Paid in Advance | The annuity income is paid at the beginning of the payment period, e.g. month/year. |
| Paid in Arrears | The annuity income is paid at the end of the payment period, e.g. month/year. |
| Protected Rights Annuity | The part of a pension fund used to contract out of additional State Pensions (SERPS /S2P), must buy a protected rights annuity. |
| Purchased Life Annuity | An annuity bought with your own money, not using your pension fund. |
| Single Life | A pension annuity that stops paying income when the pension owner dies, there's no income for their spouse or dependents. |
| With Proportion | If income is paid in arrears and the owner dies before the next payment, the balance owed is paid to their estate. |