What you need to know before trading in your annuity

George Osborne’s radical pension freedoms are set to be extended to millions of people who have already bought an annuity from April next year.

However, a combination of strict regulatory controls, high costs and uncertainty over who will actually buy annuities means the future of the market is anything but clear.

So what do you need to consider before cashing-in your guaranteed retirement income policy?

How do I know if my annuity is poor value?

Many annuities were sold on a ‘one-size-fits-all’ basis in the past, without taking into account investors’ personal circumstances or income needs.

You are more likely to have been sold a poor value annuity if you bought it straight from your existing provider rather than shopping around the market.

Similarly, if you had a medical condition but didn’t disclose it before buying your annuity, it’s more than likely you got a bad deal. Most insurers now offer a better rate to customers who are ill because, bluntly, they expect them to die sooner.

How much will it cost?

The Financial Conduct Authority (FCA) has set out how it plans to regulate the so-called ‘secondary’ annuity market.

There are a number of key rules the regulator wants to introduce to protect consumers:

• If your annuity is valued above a certain level (yet to be confirmed), you will have to pay for regulated financial advice before cashing in your policy;
• If you want to sell your annuity to your existing insurance provider, you will need to go through a broker first;
• Brokers will be required to charge a clear fee for their service, paid for either from the pension pot or upfront;
• Both brokers and firms wanting to buy annuities will be required to display the value of the offer, minus any charges, and the value of the policy on the open market.

The FCA feels these protections are necessary to stop consumers being ripped off, but they are also likely to add considerable cost to the process. If you want to take advantage of the reforms you will need to think carefully about why you need the money now, and how you will manage without the guaranteed income you are sacrificing.

Will I have to pay more tax?

Aside from the costs associated with selling an annuity, you should consider how cashing in your policy will affect your tax position. Withdrawals will be taxed in the same way as income – if this pushes you into a higher tax bracket, the consequences could be severe.

This tax problem can be mitigated if, rather than taking a lump sum, the value of your annuity is shifted directly into a flexi-access drawdown account and the money taken out in smaller chunks.

How will my spouse be affected?

Spouses or dependants could also lose out on valuable pension income if you trade-in your annuity.

Under proposed Government rules if you sell an annuity with “contingent benefits” – such as a joint-life policy – you will receive the entire value of the income. This means any income that would have been due to your dependants when you die will no longer be paid.

You should read the small print in your contract and speak to your provider or adviser to make sure you are fully aware of how swapping an annuity for cash will impact your loved ones.