When the time comes to take an income from your pension , most of you will probably buy an annuity. An annuity converts the lump sum from your pension scheme into a guaranteed income for life.
Sounds simple enough, doesn't it? But there are a few snags:
- Annuity rates are set for you when you buy your annuity. Once you've bought the annuity, you're stuck with that rate until you die.
- Right now, annuity rates are low. In the 90s, rates reached a high of 14-15 per cent, so a pension pot of say, £50,000 would provide an annual income of about £7,000. These days, annuity rates -- which are affected by interest rates and the returns on gilts (government bonds) -- have dropped to more like 7 per cent. This means the same pot will only give you an income of roughly half.
- Your annuity usually only lasts as long as you do. If the worst were to happen, the value of your capital will be lost even if you have only received a small amount of income so far. You can add in guarantees which ensure your annuity pays out for five or ten years regardless. You can also add benefits for your spouse/civil partner, but this will reduce the income you can take in your own right.
- Annuities are not automatically inflation-proofed so the value of your income will erode over time. If you choose an annuity which is index-linked, the initial income you receive will be lower.
All this adds up to quite a conundrum if you want to make the most of your pension fund. If you don't want to be locked-in to an annuity, you could choose income drawdown -- or what is now known as unsecured pension (USP) -- instead. This allows you to draw an income from your pension fund while it remains invested.
USP has some great benefits. Because your pension is still invested, you can take advantage of any future stock market growth, and you may be able to draw a higher income. What's more, by not giving up your pension to an annuity company, you'll retain control over your fund.
But -- on the downside -- you'll still be exposed to investment risk. If your pension fund performs poorly it could jeopardise your income. Because of this risk and the charges for running the plan, USP is only really suitable if you have a pension fund of £100,000 plus.
Third Way Annuities
So it would seem neither a conventional annuity nor USP are the perfect retirement solution. But a new product has been launched onto the UK market which could be the answer -- a `third way' annuity.
Only a few plans are available at the moment from a handful of companies including The Hartford and Aegon. But big players such as Standard Life and Prudential will soon be getting in on the act, meaning third way annuities should become more widespread.
In a nutshell, a third way annuity is a halfway-house between conventional annuities and USP. It provides exposure to riskier assets -- such as shares -- but also guarantees to provide you with a minimum level of income.
Even if your pension performs poorly, you'll still get the same income giving you peace of mind. But, crucially, if the assets in your pension do well your income could rise significantly.
How much income will you get?
Here's an example of the annual minimum guaranteed income you could receive, taken from Aegon's `Income for Life' plan.
| Your age when you start taking an income | Guaranteed income: single-life option | Guaranteed income: joint-life option |
|---|---|---|
| 55 to 59 years | 4.5% | 4.0% |
| 60 to 64 years | 5.0% | 4.5% |
| 65 to 69 years | 5.5% | 5.0% |
| 70 to 74 years | 6.0% | 5.5% |
| 75 years | 6.5% | 6.0% |
These figures are a percentage of your pension fund. The guaranteed minimum income rises in line with the plan's highest ever cash-in value, which is recalculated every year. If your pension has performed well, your income will increase, but it will never fall below its guaranteed minimum level (as long as it continues to meet HMRC rules on maximum withdrawals).
Another plus is that you can switch to a conventional annuity at any time and you still have the option of taking up to 25% of your fund as tax-free cash, just as you would with a conventional annuity or USP.
Here's a quick rundown of how third way annuities compare:
Third Way Annuity versus Conventional Annuity & USP
| Third Way Annuity | Conventional Annuity | USP/Income Drawdown | |
|---|---|---|---|
| Control over your fund | Yes | No | Yes |
| Guaranteed income | Yes | Yes | No |
| Exposure to future stock market gains | Yes | No | Yes |
| Protection against stock market falls | Yes | Yes | No |
| Guaranteed lump sum death benefits (up to age 75) | Yes | No | No |
Source: Aegon
A third way annuity appears to tick all the boxes, but -- and here's the drawback -- the income guarantee doesn't come for free.
Cost of the income guarantee
Each year you'll be charged a fee that covers the cost of providing the guaranteed income. This varies so you'll need to compare how different plans measure up. With Aegon's plan the guarantee will cost between 0.5 and 1.6 per cent a year depending on the percentage of shares held in your pension fund (the greater the share content, the higher the cost). Meanwhile, with The Hartford's plan the guarantee costs 0.75 per cent.
There are other charges to consider on top, such as the cost of setting up your plan, management charges on the funds you invest in and payment to your financial adviser. This can make third way annuities expensive, so you'll need to decide whether the extra guarantee justifies the cost.
If you're thinking third way annuities seem like the best of both worlds, they're usually only available through financial advisers, so this should be your first port of call.
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