8

I already knew about pensions, but I’ve just heard of annuities today. The DifferenceBetween.net article “Difference Between Annuity and Pension” says,

A difference that can be seen between pension and annuity is in the payment amount. The pension is determined by the sum that one has earned during his service and adjusted for the duration of his career. Annuity is a scheme that is determined by the amount of investment made by a person towards the scheme.

I’m still not clear exactly what this means. I would appreciate a clearer explanation.

Also, with either scheme, can I still work part-time after I “retire”, or might this affect the pension/annuity?

7

There are broadly two kinds of pension: final salary / defined benefit, and money purchase.

The text you quote above, where it talks about "pension" it is referring to a final salary / defined benefit scheme. In this type of scheme you earn a salary of £X during your working life, and you are then entitled to a proportion of £X (the proportion depends on how long you worked there) as a pension. These types of scheme are relatively rare now (outside the public sector) because the employer is liable for making enough investments into a pot to have enough money to pay everyone's pension entitlements, and when the investments do poorly the liability for the shortfall ends up on the employer's plate. You might have heard about the "black hole in public sector pensions" which is what this refers to - the investments that the government have made to pay public sector workers' pensions has not in fact been sufficient.

The other type of scheme is a money purchase scheme. In this scheme, you and/or your employer make payments into an investment pot which is locked away until you retire. Once you retire, that pot is yours but there are restrictions on what you can do with it - you can use it to purchase an annuity (I will give you my £X,000 pension pot in return for you giving me an annual income of £Y, say) and you can take some of it as a lump sum. The onus is on you to make sure that you (and/or your employer) have contributed enough to make a large enough pot to give you the income you want to live on, and to make a sensible decision about what to do with the pot when you retire and what to use it as income.

With either type of scheme, you can claim this pension after you reach retirement age, whether or not you are still working. In some schemes you are also permitted to claim the pension earlier than retirement age if you have stopped working - it will depend on the rules of the scheme. What counts as "retirement age" depends on how old you are now (and whether you are male or female) as the government has been pushing this age out as people have been living longer.

In addition to both schemes, there is also a "state pension" which is a fixed, non-means-tested, weekly amount paid from government funds. Again you are entitled to receive this after you pass retirement age, whether or not you are still working.

  • 2
    A good answer (+1) but I want to add that at least in the US, the "black hole in public sector pension systems" is not because the government's investments have failed to produce a return adequate to support the pensions, but that the investments were never made when they should have been made. If the government had kept its promise to fund the pension system properly, there would not be a shortfall in any US public pension system. – Dilip Sarwate Apr 17 '15 at 20:04
  • @DilipSarwate, fair point, thanks for the clarification. – Vicky Apr 17 '15 at 20:45
  • 1
    The restrictions on what you can do with pension savings in the UK have been loosened a lot in the past year or 2. AIUI it is now practical to keep your money invested after retirement and draw income, or draw the capital out slowly. Buying an annuity is now no longer the only, or typically the best, option. – Nigel Harper Apr 20 '15 at 14:45
4

Pension in this instance seems to mean pension income (as opposed to pension pot). This money would be determined by whatever assets are being invested in. It may be fixed, it may be variable. Completely dependant on the underlying investments.

An annuity is a product. In simple terms, you hnd over a lump sum of cash and receive an agreed annual income until you die. The underlying investment required to reach that income level is not your concern, it's the provider's worry. So there is a hige mount of security to the retiree in having an annuity.

The downside of annuities is that the level of income may be too low for your liking. For instance, £400/£10,000 would mean £400 for every £10,000 given to the provider. That's 4% and would take 25 years to break even (ignoring inflation, opportunity cost of investing yourself). Therefore, the gamble is whether you 'outlive' the deal. You could hand over £50,000 to a provider and drop dead a year later. Your £50k got you, say, £2k and then you popped your clogs. Provider wins. Or you could like 40 years after retiring and then you end up costing the provider £80k. You win.

Best way to think of an annuity is a route to guaranteed, agreed income. To secure that guarantee, there's a price to pay - and that is, a lower income rate than you might like.

Hope that was the kind of reply you were hoping for. If not, edit your OP and ask again.

Chris.

PS. The explanation on the link you provided is pretty dire. Very confusing use of the term 'pension' and even if that were better, the explanation is still bad due to vagueness. THis is much better: http://www.bbc.co.uk/news/business-26186361

3

An annuity is a product. In simple terms, you hand over a lump sum of cash and receive an agreed annual income until you die. The underlying investment required to reach that income level is not your concern, it's the provider's worry. So there is a huge mount of security to the retiree in having an annuity.

It is worth pointing out that with simple annuities where one gives a lump sum of money to (typically) an insurance company, the annuity payments cease upon the death of the annuitant. If any part of the lump sum is still left, that money belongs to the company, not to the heirs of the deceased. Fancier versions of annuities cover the spouse of the annuitant as well (joint and survivor annuity) or guarantee a certain number of payments (e.g. 10-year certain) regardless of when the annuitant dies (payments for the remaining certain term go to the residual beneficiary) etc.

How much of an annuity payment the company offers for a fixed lump sum of £X depends on what type of annuity is chosen; usually simple annuities give the maximum bang for the buck. Also, different companies may offer slightly different rates.

So, why should one choose to buy an annuity instead of keeping the lump sum in a bank or in fixed deposits (CDs in US parlance), or invested in the stock market or the bond market, etc., and making periodic withdrawals from these assets at a "safe rate of withdrawal"? Safe rates of withdrawal are often touted as 4% per annum in the US, though there are newer studies saying that a smaller rate should be used. Well, safe rates of withdrawal are designed to ensure that the retiree does not use up all the money and is left destitute just when medical bills and other costs are likely to be peaking. Indeed, if all the money were kept in a sock at home (no growth at all), a 4% per annum withdrawal rate will last the retiree for 25 years. With some growth of the lump sum in an investment, somewhat larger withdrawals might be taken in good years, but that 4% is needed even when the investments have declined in value because of economic conditions beyond one's control. So, there are good things and bad things that can happen if one chooses to not buy an annuity.

On the other hand, with an annuity, the payments will continue till death and so the retiree feels safer, as Chris mentioned. There is also the serenity in not having to worry how the investments are doing; that's the company's business. A down side, of course, is that the payments are fixed and if inflation is raging, the retiree still gets the same amount. If extra cash is needed one year for unavoidable expenses, the annuity will not provide it, whereas the lump sum (whether kept in a sock or invested) can be drawn on for the extra expense. Another down side is that any money remaining is gone, with nothing left for the heirs. On the plus side, the annuity payments are usually larger than those that the retiree will get via the safe rate of withdrawal method from the lump sum. This is because the insurance company is applying the laws of large numbers: many annuitants will not survive past their life expectancy, and their leftover monies are pure profit to the insurance company, often more than enough (when invested properly by the company) to pay those old codgers who continue to live past their life expectancy.

Personally, I wouldn't want to buy an annuity with all my money, but getting an annuity with part of the money is worthwhile.

Important: The annuity discussed in this answer is what is sometimes called a single-premium or an immediate annuity. It is purchased at the time of retirement with a single (large) lump sum payment. This is not the kind of annuity that is described in JAGAnalyst's answer which requires payment of (much smaller) premiums over many years. Search this forum for variable annuity to learn about these types of annuities.

1

With an annuity, you invest directly into an annuity with money you have earned as wages/salary/etc. You pay for it, and trade your payments into the annuity for guaranteed payments from the annuity issuer in the future. The more you pay in before the annuity payments begin, the more you will receive for your annuity payment.

With a pension, most often you invest implicitly, rather than directly, into the pension. Rather than making a cash contribution on a regular basis, it is likely that your employer has periodically invested into the pension fund for you, using monies that would otherwise have been paid to you if there were no pension system. This is why your pension benefits are often determined based on years of service, your rate of pay, and similar factors.

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.