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Retirement planning Financial planning
31 July 2023
Author: Punter Southall Aspire

Turning your pension into an annuity: a short guide

If you have decided to buy an annuity with your pension pot, how does the whole process work?

With many financial products - such as life insurance - you pay a monthly premium with little/no up-front payment. However, when buying an annuity, things work differently. It could be one of the biggest lump sum payments you ever make. 

Given the potential sums involved, it helps to know how the process works. Below, we explain how a pension pot can be turned into a guaranteed retirement income by buying an annuity.  

How do I convert my pension into an annuity?

In simple terms, buying an annuity involves moving funds from your pension to an annuity provider, generally an insurance company. The process might take a month or so to complete. 

Buying an annuity used to be the only option for someone’s pension savings. Today, however, you have far more choices. You could buy an annuity from a provider outside of your existing pension scheme or you might choose income drawdown instead. 

Income drawdown will likely be the “default” option for your pension pot. Here, your pension money stays invested and you can choose to take a regular income from it when you are ready, after the age of 55.  

Your scheme may offer you a range of annuity quotes as you approach your retirement date. Yet you are not obliged to accept them. You can - actually, you MUST - shop around, perhaps with the help of a financial adviser, to make absolutely sure you are being offered the best deal. 

If you have a final salary or “defined benefit” pension , then there is no “pot” of money to transfer readily to an annuity provider. In some cases, it is possible to transfer a pension like this to a defined contribution scheme, to unlock the cash (“transfer value”) from it. 

In this case, the released cash could be used to buy an annuity. However, the transfer process is complex and you should speak to a financial adviser about your options. By law, you must do so if you have more than £30,000 in such a pension.  

In many cases, a final salary pension is simply a better version of an annuity. Both can provide a guaranteed retirement income, but the former may offer you a higher income and better benefits. 

Choosing from annuity options

There is no single type of annuity. Rather, there are many options to tailor to your needs. To help you sift through the options, it helps to ask yourself some questions. 

Firstly, do you want your annuity to pay out to someone (e.g. your spouse) when you die? If so, then a “joint life” annuity can offer continuing benefits to a surviving dependent. 

Alternatively, a single life annuity (in its simplest form) will likely pay a higher income compared to a joint life annuity. Yet the income will stop when you die.  

Another option could be a “nominee annuity” if you want a named person to receive an ongoing annuity after your death. At this point, your own annuity ends and another standalone annuity (with its own terms and conditions) comes into effect for the person in question. 

If your initial beneficiary dies, then you can arrange to buy a “successor’s annuity” using the remaining money in your pension drawdown arrangement. 

You should also ask yourself whether you want your annuity income to remain stable or increase. The former will be offered by fixed/level annuities, which tend to offer a higher initial income but the value dwindles over time as inflation erodes its buying power. 

Conversely, an increasing annuity will go up each year - either at a defined rate (e.g. 3%) or in line with an official inflation measure. This helps to preserve the power of your income. However, your starting income will probably be lower than a level annuity. 

A third question to ask is whether you want to include a “guarantee period” on your annuity. If you die shortly after buying an annuity, it can die with you. However, by guaranteeing some/all of your income, it will continue to pay out for a minimum term to someone you have nominated. 

This could be an option if you want to provide a “death benefit” to your loved ones, should you die prematurely. Another, similar option is “value protection” which pays out a lump sum to beneficiaries. For instance, if you paid £100,000 for an annuity and only received £50,000 from it, then £50,000 would be paid to your beneficiary. 

How should I receive my annuity?

You can normally choose from a range of options regarding the frequency of your annuity income. For instance, your provider might let you take an income monthly, quarterly or annually. 

Payments might be available in advance (at the beginning of the payment period) or in arrears. They could be made with or without “proportion”. This refers to what happens to your income when you die. 

“With proportion” means that you get a partial payment based on the date you died relative to your annuity income payment. For instance, if you die 15 days after you get an income payment, then the annuity should pay out another 15 days’ worth of income. 

Without proportion means that your annuity will not make this final payment. 

Another option to consider is whether you want “with overlap” or not. This stipulates when a dependent should start getting annuity income after your death. 

“With overlap” means that your beneficiary’s annuity (e.g. a successor annuity) will start paying out immediately after you die - even if this happens during a guarantee period. 

“Without overlap” means that, if you die during a guarantee period, then your beneficiary will not start receiving annuity income until this period ends. 

For the best peace of mind about your annuity options, please speak with a financial adviser to ensure that you fully understand the process of turning pension funds into a guaranteed retirement income for life. 

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