Is it time to say goodbye to annuities?

October 10, 2019
Taryn Lee-Johnston

Times change but sometimes it can take a while for established systems to catch up with this fact. For example, it took until 2015 for the law to recognise that using a pension pot to buy an annuity was not necessarily the right approach for everyone and to make it possible for people to use their pensions savings in a more flexible manner.  For some people, this may be a huge step forward, but for others, an annuity may still be the best option.

The development of pensions

The basic concept of a pension is that a person saves during their working years and then uses the savings to generate an income for their post-work years.  Governments used (and continue to use) tax breaks as a means of encouraging people to save for their later years but, up until 2015, the price of accepting these tax breaks was that the majority of the money saved into a pension pot had to be used to buy an annuity by the time of the individual’s 75th birthday.  This ensured that the funds saved were used to produce an income for the individual right up to their death (although the government had no control over how the income would be spent).  In 2015 the government removed the requirement to spend pension savings on an annuity and thus introduced a new era of pensions freedoms.

The new pensions landscape

 

Those with pensions savings are still at perfect liberty to use all or part of them on an annuity if they so wish.

Alternatively, they may opt to cash out their pension pot in its entirety, (although there will be a hefty tax penalty for this).

Last but by no means least, they may opt to keep their pension pot wholly or mostly invested and use it to generate an income to keep them in retirement.

Annuities versus pensions freedoms – pros, cons and tax treatment

An annuity is simply a guaranteed income for life and the income from annuities is hence subject to income tax.  The straightforward nature of annuities may be a pro or a con depending on your point of view.  People who value stability and simplicity may be perfectly happy to buy an annuity which gives them a guaranteed, fixed income until the end of their days, even if they think they could have achieved better returns through the stock market.  By contrast, people who consider themselves capable investors might chafe at the fact that annuities do not necessarily provide the sort of returns they could potentially have achieved themselves.

Pension freedoms, by contrast, can largely mean whatever the holder of the pension pot wants them to mean so the income generated from the pension fund will be taxed according to its nature, for example if it is used to generate dividend income then it will be subject to dividend tax.

A point which may be important to some people is that, in principle, pension pots can now be passed on from one generation to another and as such it can be wise to include them as part of the estate-planning process in order to maximize the funds which go to the individual’s chosen heirs rather than HMRC.

As with annuities, the flexibility of pensions freedoms may be a pro or a con depending on your point of view.  If you are the sort of person who relishes a challenge, then you might be very happy to take your chances as an investor and aim to achieve better returns than you would have received from an annuity, particularly if you are still a younger retiree and may have decades still to live.

 

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