The usual way to obtain a pension in retirement is to save up a considerable sum of money, and then to go to an insurance company to buy an annuity. This is a contract for the insurance company to pay an income to the annuitant for the remainder of his or her life. In the classical annuity, if you buy it and then die the next day, you get nothing. If you live a very long time, you do well out of it. There are various schemes for paying a guaranteed amount for a number of years whether you live or not, but all they are doing is returning your capital plus a bit of interest. That interest is derived from investments in Government bonds since anything else would be just too risky.
The State allows people to defer some of their income and to invest it in a pension fund. When the pension comes to be paid as an annuity, it is then subject to income tax, which gives some fairness to the rules from the State’s point of view. This is still advantageous to the pensioner because income can be shifted out of the 40% or 20% tax bracket and into the 20% or 0% tax bracket, so saving for a pension is also good tax planning. In addition in the UK, something like 25% of the pension fund can be taken as a tax-free lump sum, which is the one big tax break that most people get in their lives.
There is another type of pension to know about. Suppose that you take that 25% lump sum, and put it together with some money which you have inherited. You may then have enough to buy a purchased life annuity. The tax treatment of this is different, because much of the “income” from this annuity is merely return of capital. The insurance company will provide the annuitant with a statement showing the split between return of capital and income, and if the annuitant’s tax return is prepared by an accountant, then the accountant should make sure to get it right.
Another way in which a purchased life annuity can come into existence is after an industrial accident where the victim is compensated by a large sum of money. None of this is taxable because it is merely restitution, and in practical terms it would be very objectionable if getting your arm chopped off resulted in a gain for the Revenue. The compensation can be used to buy a purchased life annuity, and obviously we need to get it right about the tax treatment because we would not want an invalid paying any tax at all if we can help it. We are very likely to see the situation where the State pension plus the income element of the annuity is less than the annual allowance, so no tax is due and no annual tax return needs to be filed. However if we mistakenly include the return of capital as income, then income tax is apparently due and a tax return has to be filed. We don’t want an invalid in retirement having to suffer this!