When it pays to take income instead of annuity
Sunday 06 August 1995
Essentially, the choice is between buying an annuity straight away or taking income from the fund and buying an annuity later. What factors should the investor - and his or her adviser - take into account in deciding which course to take?
The overriding consideration is the flexibility of the new arrangements. The decision to buy an annuity is irrevocable - the amount of income provided by the annuity is predetermined, either in money terms or by a set formula, and the investor is left with the consequences of that decision. He or she cannot subsequently change it.
By contrast, taking income from the personal pension contract gives the investor considerable flexibility over the amount of income taken and the timing as to when the annuity is eventually bought. This flexibility becomes apparent when one considers the complex calculations that have to be made when buying an annuity.
The first consideration, which is not given much attention in the media, is what type of annuity to buy. Where to buy the chosen annuity - from your fund manager or the open market - is very much a secondary consideration.
In selecting the annuity, the investor has to consider:
q The initial income level.
q The rate of future increases in that income.
q Whether the income payments are guaranteed, irrespective of when the investor dies and the period during which they are guaranteed.
q Whether income payments will continue to be paid to the investor's spouse after his or her death, and if so at what level.
The largest initial income is provided on a level annuity with no increases in that income and with payments ceasing on the death of the investor whenever that may occur.
The greater the increases in income and the longer the payments are guaranteed, the greater the reduction in the initial annuity payments.
If a spouse's benefit is required, then a further reduction would be made depending on the amount of income required and the age difference between the investor and his or her spouse.
The table shows the variation in gross income for differing types of annuity bought now from Equitable Life, a leader in annuity business, for the same cash sum.
By contrast, under the income withdrawal facility, the investor simply decides each year how much income to take from the contract between the maximum and minimum amounts - limits that are based on the investor's age and sex and the gross redemption yield on 15-year gilt stocks. The current limits allow a maximum monthly income of pounds 950 from an investment fund of pounds 100,000.
Under these circumstances, choosing to take income from the contract would appear to be far less troublesome than buying an annuity, although eventually an annuity will have to be bought, unless the investor dies in the meantime. In addition, a comparison of both tables shows that the investor can get more income from the withdrawal facility than from buying an annuity, other than buying a level annuity with no increases and no spouse's benefit.
In addition, the investor's spouse is automatically protected should he or she die before buying the annuity. In this event, the spouse has the choice to:
q Continue income withdrawals from the contract and buy an annuity later.
q Take the remaining value of the contract and either buy an annuity or take the cash sum, less a tax charge of 35 per cent.
All of which suggests taking income is far more advantageous. But it is not quite that simple, as I will discuss next week.
How annuities pay out
Man aged 65, wife aged 62. Monthly annuity bought with pounds 100,000.
On life of man only With 50% spouse benefit
No guarantee g'teed No guarantee g'teed
5 years 5 years
Level payments 967.42 947.50 857.25 849.25 Rising 5% pa 653.25 642.33 544.08 642.33 Rising with RPI 663.08 652.00 553.75 549.75 Unit linked* 469.67 463.33 367.50 365.50
* Annuity payments vary with the price of the underlying units. Payments continue to the wife after the death of the man at 50 per cent of the full value.
Source: Equitable Life
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