What’s the deal with Annuities

Annuities, pensions and pensioner bonds are all terms that have been banded around over the last few days. So what does all this jargon actually mean? Lets take a look:

The textbook explanation –

During an individual’s working life they are expected to save into a pension and in doing so build up a pension pot. During the first few years of retirement, the individual will then use the money that they have saved to buy an annuity from an insurance company. This is a transaction that occurs once, and only once.

An annuity is an annual retirement income that is paid to them for the rest of their life.

Before the Chancellor’s 2014 budget there was a requirement to buy an annuity for those who had saved into a defined contribution pension. Now, however, this requirement has been scrapped and the individual is left to decide what to do with their own pension pot.

Lost… Ok, picture this:

It’s the 1^st of   December – Christmas fever is rising, festive excitement brewing and advent calendars are at the ready.

So lets suppose your advent calendar is like your pension pot and the 25 day run up to Christmas represents your remaining days.

Your wealth is the 25 chocolates.

Under the previous rules, if your pension was unrelated to your employment, you were required to buy an annuity. In a metaphorical sense handing over the advent calendar to an insurance company who would allow you to have one chocolate a day.

Your annual income (in this case a daily chocolate stream) is assured.

Now, under the new reform, it is up to the individual what they want to do with their chocolates: they can still buy an annuity and be guaranteed one chocolate a day or they can take all their chocolates out of the advent calendar on the 1^st of December.

 

What they then do with those chocolates is up to the individual.

 

So lets suppose that Johnny has an insatiable desire for chocolate and prone to overindulge. He takes all of his chocolates out on the 1^st of December and stores them in his fridge; he has no concern about opening his advent calendar doors days before it is recommended to do so.

However during the day Johnny cannot resist the ‘occasional’ chocolate from the fridge. They are beckoning him ‘Johnny, eat me, eat me…’

Before Johnny realises what he has done, he has eaten all 25 chocolates in one day and thus consumed his wealth. His avarice, myopia and desire for instant gratification overrode any rational long term thought and planning; he has depleted all of his personal wealth and must now rely on the state pension.

 

Johnny’s empty and eaten advent calendar is analogous to an empty pension pot

On the other hand Flossy is more conservative and likes to plan ahead. She is worried about her wealth running out so after taking her pension pot – in our case the advent chocolates – she decides to invest some of them in one of Mr Osborne’s new pensioner bonds.

Providing dear old Flossy is over the age of 65 she can purchase a pensioner bond and receive some interest (2.8% this year) on her investment. In the advent calendar world this is akin to setting aside 5 chocolates in exchange for a promise of more chocolates in the future when the bond is cashed in – or ‘melted’.

Whether you follow the Flossy route of investing, the Johnny route of consuming or the conventional annuity-purchasing route is up to you.  The Chancellor has promised to offer free impartial advice to help individuals decide on what is best for them.

So there you have it – advent calendars and annuities.  How smart-ie are you?