Annuity Purchase
Introduction
An annuity is a financial product that converts capital into income. You hand over a lump sum of money in return for a stream of income payable for a defined period of time, or, as is often the case, until your death.
There are two basic types of annuity - those that you choose to buy but are not required to buy, known as purchased life annuities; and those that are purchased with funds from a pension scheme, known as scheme annuities or compulsory annuities. This guide focuses on compulsory annuities.
When you buy an annuity, the income you receive consists partly of interest on your capital and partly of a return of your capital. All the income you get from a pension scheme annuity or compulsory annuity is taxable as earned income. The tax treatment of purchased life annuities is different.
Your pension is liable to income tax at your individual tax rate(s) and will be taxed at source by the annuity provider. Any pension payment due after your death, particularly payments due under any guarantee options will form part of your estate, which could be liable to Inheritance Tax if your total estate exceeds the IHT zero-rate band.
The level of income you receive from your annuity is usually quoted as an annual percentage return. Thus an annuity offering a rate of 7% would mean that to create an annual income of £7,000 you would need to have a pension fund worth £100,000. It will be affected by a number of factors. The two most important are long-term interest rates on government bonds (Gilts) and your life expectancy.
Introduced in the Finance Act 1978, the Open Market Option allows you to transfer your pension fund from one life assurance company to another to get a better, higher annuity rate. You must exercise an Open Market Option before any benefits are drawn from your existing life assurance company in the form of an income or lump sum.
Generally speaking once you have bought an annuity there is no way back - you have permanently exchanged your pension fund for a lifetime income. Quite simply the decision to buy an annuity is going to be one of the biggest and most important financial decisions of your life.
Following the A Day pensions law changes, assurance companies are able to offer a wider range of annuities, including limited period annuities that run for a set length of time or money back annuities (also known as value protected annuities) that return funds on your death less payments already made, and less 35% tax. Bear in mind that any such bells and whistles or special features on your annuity will have the effect of driving down the return on your funds that it is likely to offer.
Once you are in the process of purchasing an annuity, your adviser will provide you with quotations from annuity providers. It is normal that most providers only guarantee their quotations for a short period of time. In total, you will have at least 30 days after you receive the first quotation to consider whether to proceed. Once you have sent back the application form and the annuity has been set up the decision will be final. You will not be able to change your mind.
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