About open market option
Many people retiring in the UK over the next few months will have received information about their pension fund from the provider, including details for buying annuities. The provider's annuity offered, however, may not be competitive and an open market option could add up to 30% more pension income each year for the rest of the annuitant's life.

An open market option means an annuitant is free to buy a compulsory purchase annuity (or pension annuities) from any provider in the market, and this applies to a with profits annuity as well as a standard annuity. Although every one of the approximate 350,000 people retiring in the UK in 2011 could consider an open market option, but over 2/3rds still did not shop around to find the best annuities. Many could receive extra income by up to 30%, worth thousands of pounds every year for the rest of their lives.

Buying the right pension income is very important as once bought, annuities cannot be switched to another annuity provider, cannot be changed to a different type of annuity and cannot be altered in any way for the rest of the annuitant's life. Once the capital from the pension fund has been spent on an annuity, there is no opportunity for any of this capital to go to a beneficiary on the death of the annuitant.

There are many aspects to the retirement options. These could be the features that can be added to annuities, whether an individual suffering from ill health, is a smoker or is overweight could benefit from an enhanced or impaired life annuity, whether other options are more appropriate such as phased retirement of pension drawdown and how to select the best annuity rates offered by providers which can change from one week to the next depending on their cashflow requirements.

It is important that if an individual is in any doubt when taking the open market option route, they must seek an annuity and pension bureau offering specialist advice from an independent financial adviser (IFA). The advice given is paid for by the annuity provider as part of their distribution costs, even if an individual goes direct. Advice has the added security that if the annuity is inappropriate to your needs, there is a route for complaint and compensation.

At retirement the individual can use a money purchase fund, personal or company, to buy an annuity using an open market option to search for the highest pension annuity. Once you have purchased an annuity it cannot be changed, so learn more about annuities, compare annuity rates and before making a decision at retirement, secure a personalised annuity quote offering guaranteed rates.


Cost of delay
Currently many people believe that standard annuities from their existing provider offer "poor value for money". Given that many of them already receive incomes from a final salary or public service schemes, they may not need the income from other pension arrangements they have accumulated such AVC, FSAVC, retirement annuity or personal pensions and therefore decide to delay purchasing pension annuities.

At an individuals retirement date, by delaying the purchase of a standard annuity by a year, the annuitant will have lost one years income and this cost of delay is far greater than any possible increase in rates in a years time. The annuitant must also consider the benefit of enjoying the income now and for longer when they are healthy, as there is a greater likelihood of ill health the older the annuitant becomes.

For example, take a male or female with £100,000 in a pension choosing an open market option level annuity, no guarantee paid monthly in advance, assuming that the existing fund continues to grow at 5.0% per annum (after charges) and retiring at ages 55, 60 and 65. By delaying either 1, 3 or 5 years it will take a number of years before a deferred higher annuity income will 'catch-up' with the income already paid, or number of years to break even. This time could be longer than the individuals life expectancy (years to live), or mortality as follows:

The above tables assume the fund is based on equities, it grows at 5.0% per annum (after charges) and that there is no improvement in the annuity rates in the future. If the fund does not increase during the delayed period, all of the above examples will not break even during the annuitants lifetime.

The tables clearly show the effect of mortality drag by the annuitant not participating in the benefit of annuities. If the annuitant is not dependant on the income from their other pension arrangements and willing to accept a slightly higher risk, a with profits annuity would allow them to receive an income now and therefore avoid the cost of delay.


Single or joint annuity
For a compulsory purchase annuity acquired from a pension fund using an open market option, it must be taken between the ages of 50 to 75 years whereas a purchased life annuity can be bought at any time. Both annuity types can be purchased as single life annuities where the annuitant does not have a partner and this feature can also apply to a with profits annuity.

This means that the pension income from a single life annuity will be greater than a joint life annuity because due to mortality, it is going to be paid out for a shorter period of time. The annuity is paid for the life of the annuitant and ceases on death.

If the annuitant is married or has a partner that does not have a source of independent income, then the annuitant may want to share their pension income or the income from a lump sum by using a joint life annuity, providing security on the death of the annuitant by paying a survivors pension.


Survivors pension
For a joint life annuity the partner will receive a survivors pension on the death of the annuitant and this feature can also be added to with profits annuities. The amount of the income is selected at the outset by the annuitant and payable for the whole of the survivors life, cease on their death. A dependent could also receive an income, such as children but this would normally be paid until age 18 years or the end of further education.

Using an open market option the annuitant can select the percentage of their annuity income to be paid to their partner in the event of death. An equal amount is known as a 100% survivors pension and other typical percentages would be half or 50% survivors pension, two thirds or 66.67% survivors pension, although any percentage can be selected. The higher the spouse's pension selected the lower will be the pension income paid to the annuitant.


Mortality factor
The expected ages at death are reflected in the price paid for pension annuities. Some annuitants live beyond these life expectancies and as a result, receive more money from the annuity income than the original pension fund plus interest. In the UK the average life expectancy for a person depends on their current age as the following table shows.

Other annuitants die early and receive only a fraction back from their original pension fund capital and creating a mortality profit for the insurance company. Part of this money is returned to the other annuitants in the form of more income. This means that for an individual who invests through pension fund withdrawal, to match the return in an annuity an extra return is required. This has the effect of creating a mortality drag on the pension.

This means that an individual with poor health and lower life expectancy will find annuities unattractive. As a result, life companies offer enhanced or impaired life annuity for people with shorter life expectancies such as smokers, people that are overweight, of a certain occupation or even living in a particular location in the UK. Such open market option annuities can add as much as 30% to the standard annuity rates, or even more for an impaired life or enhanced annuity.


Shop Around for a Pension Annuity and Save

On retirement most people use their accumulated pension fund to purchase a pension annuity. This pension annuity should provide an adequate annual income for a comfortable life in retirement, and the best way to find the best annuity available is to shop around on the open market.

By using your open market option you have a much greater choice of annuities and annuity rates, which can differ significantly depending on provider and other factors such as your lifestyle and your health. Here at Sharing Pensions our aim is to help you find the best possible pension annuity by comparing annuities on the open market.

The benefits of doing so can be great and you could even increase the income from your pension annuity by up to 25%. That can equate to a serious amount of money and it could make all the difference to your quality of life once you have retired. 

So, if you are planning to buy a pension annuity, use Sharing Pensions to browse the market and find one that suits your needs and provides you with the most income.


Level annuity
By purchasing a level annuity income, an annuitant will receive a greater income initially than if they purchase an open market option annuities with RPI escalation or fixed rate escalation. If inflation remains low, it could take more than 20 years for a pension annuity with escalation matches the return from a level annuity. One way of having a higher income is to initially select a with profits annuity. This can pay an income in retirement that is higher than the level annuity.

Therefore, if the annuitant is aged 65 and dies at the age of 85, there would be no difference between a level and escalating annuity. However, if inflation rises during this time then this could significantly reduce the buying power of a level annuity income and hence reduce the annuitant's standard of living.

The timing of an annuity purchase can also make a significant difference to the income over the life of the annuitant as the following table shows. This assumes a £100,000 pension annuity purchase for a level annuity paid in arrears with no guarantee period.

For example, an annuitant with a £100,000 pension fund after taking the tax free lump sum could, with a level annuity purchase an income for a male aged 65 of £5,962 pa year in June 2012. This is compared to an annuity with 3% escalation that would provide a pension income of £4,193 a year.

Although annuity rates have been at their lowest point for the past 40 years, so long term inflation is under control within a range of 1.5% to 3.0%. This means the guaranteed income from a pension annuity whether level of escalating can offer an adequate return for the purchase price, especially when other investment options such as equities are falling or volatile.

RPI and LPI escalation
For a pension income to maintain its value in the future, it needs to rise with inflation. This means that the annuity must be indexed-linked to the Retail Price Index (RPI). Alternatively, the pension annuity could also be escalated by limited price indexation (LPI) which is inflation rises limited to a maximum of 5% growth. This basis is used for any portion of the pension fund containing protected rights benefits.

In order for the insurance company to be in a position to pay the annuitant, it must purchase index-linked gilts that provide an index-linked income and redemption values in the future. The cost of RPI escalation depends on inflation and therefore could be cheaper or more expensive than a fixed rate annuity, but certainly more expensive than a level annuity.

For example, a £100,000 pension fund after taking the tax free lump sum could, with RPI escalation, use an open market option to purchase a single life annuity for a male aged 60 of £3,366 income a year in 2011. This is compared to a level annuity that would provide a pension income of £5,944 a year in 2011. One way of having a higher income is to initially select a with profits annuity. This can pay an income that is much higher than the RPI escalating income at the start but also has the possibility of rising in the future.

Fixed rate escalation
A pension annuity is usually paid on a fixed rate basis over the life of the annuitant, either as a level annuity or escalating at a fixed percentage. Although any percentage can be selected for an open market option, the usual rates are 3% or 5% per year.

In order for the insurance company to be in a position to pay the the annuitant, it must purchase Sterling fixed interest securities such as UK Government securities or gilts. The amount of income that can be purchased with a pension fund depends on the yields for long-term gilts and in particular gilts with a redemption periods of 15 years or more.

Therefore as interest rates have fallen, so the yields on annuities have fallen and this affects the income that can be paid to an annuitant. Nevertheless, if inflation remains under control in the future at between 1.5% to 3.0%, the income from a 5% escalating annuity will slowly increase the standard of living of the annuitant over time.

For example, a £100,000 pension fund after taking the tax free lump sum could, with a fixed rate of 5% escalation, purchase a single life annuity for a male aged 60 of £3,079 income a year in 2011. This can be compared to pension annuities with RPI escalation that would provide an income of £3,366 a year. One way of having a higher income is to initially select a with profits annuity. This can pay an income that is much higher than the fixed rate escalating income at the start but also has the possibility of rising in the future.


Guaranteed period
The annuitant can decide that the annuity income using an open market option is to be paid for a guaranteed period of time from the start, typically for 5 or 10 years and this feature can also be added to a with profits annuity. This means that if the annuitant dies shortly after taking the pension annuity, the income must continue be paid for the time of the guaranteed period remaining.

The annuity can be paid as an income, usually to the estate, or the insurance company may be willing to capitalise the amount of the annuity remaining and pay this as a lump sum. This lump sum is typically less than the value that would have been paid as an income to reflect the investment loss to the insurance company of paying the money sooner.

The cost of a 5 year guaranteed period is approximately 1.7% of the annuity purchase price. For example, for every £1,000 per year income the annuitant will pay £17 per year for this guarantee, leaving a gross income of £983 per year. However, from year 6 onwards the guarantee no longer applies and if the annuitant is still alive, he or she continues to receive only £983 per year and this is not such an attractive option.


Income frequency
Depending on the individual's requirements, using an open market option the pension annuity can be paid on a monthly, quarterly, half yearly or annually and this feature can also be added to a with profits annuity. The more frequently the income is paid, the more expensive the option and the lower the annuity income.

For example, if a male aged 65 decides to take his annuity annually rather than monthly, this adds 4.2% to the annuity rate paying a higher income for the rest of the his life. For a female aged 65 this adds 3.8% to the income for the rest of her life.


Advance or arrears
For all of the premium frequency options, the annuitant can decide to take the payments from his open market option in advance or arrears. This feature can also be added to a with profits annuity. For example, if the annuitant takes a quarterly income this can be paid at the beginning of the period, in advanced, or at the end of the period, in arrears.

For example, if a male aged 65 decides to take his monthly annuity in advance, this reduces the annuity rate by 0.6% paying a lower income for the rest of the his life. For a female aged 65 this reduces the income by 0.8% for the rest of her life.


With proportion
Where the annuitant takes the income in arrears, for an open market option this can be with or without proportion. In the event of the annuitant's death during the period he or she was waiting for the next pension annuity payment in arrears, annuities with proportion will pay to the estate a proportion of the payment due.

For example, it the death occurred halfway through the month for an annuity paid monthly, then half of the annuity would be paid to the estate. The cost of proportion is low and for a male or female aged 65 with proportion reduces the income by approximately 0.2% for the rest of his or her life.


With overlap
For pension annuities on a joint life annuity where using an open market option the annuitants have selected both a guaranteed period and a survivors pension, on the early death of the annuitant only the income during the guaranteed period would be paid.

At the end of the guaranteed period the survivors pension selected would then become payable. However, if the annuity selected is with overlap, then the survivors pension is paid immediately in addition to annuitants pension until the end of the guaranteed period.

For example, a pension annuity of £10,000 has a guaranteed period of 5 years and a survivors pension of 50% with overlap. If the annuitant dies 2 years later, the £10,000 will be paid for a further 3 years and a survivors pension of £5,000 is paid immediately. The spouse receives £15,000 for 3 years and when the guaranteed period ends, only the £5,000 from the survivors pension is paid until the end of the spouses life.


Retirement age limits
As a result of Pensions Simplification, the minimum age of retirement when an individual can take their benefits has changed from 50 to age 55. This applies to taking the tax free lump sum, purchasing open market option pension annuities and income drawdown.

From 6 April 2010 it has not been possible for individuals under the age of 55 to take pension benefits. The only exceptions are the following:

Prior to A-Day the Inland Revenue did not allow an annuitant to delay the purchase of a pension annuity beyond the age of 75.

With Pension Simplification, from 6 April 2006 both money purchase occupational pension schemes and private pensions, such as personal or stakeholder pensions, are standardised under the rules. This allows an individual to purchase an annuity or continue in drawdown after the age of 75 and is known as alternatively secured income (ASI).

ASI has been introduced in particular to assist those individuals with religious beliefs that prevent them from purchasing an annuity on ethical grounds. The minimum ASI can be £0 per annum and the maximum is 70% of the Government Actuaries Department (GAD) annuity tables for an annuitant aged 75, and reviewed annually. This low limit to continue in drawing an income has been set to discourage people that have no religious reasons for not purchasing annuities.