Defaqto

What is an annuity?

An annuity is an investment which will pay you an income for the rest of your life, no matter how long you live. This is achieved by handing over your pension fund to an insurance company in return for an annuity when you retire. The insurer guarantees to pay you an income for the rest of your life via the annuity.

In the UK, there are basically two types of annuity:

• pension annuities (compulsory purchase);
• and purchased life annuities (voluntary purchase).

All annuities share the following characteristics:

• they pay a high level of guaranteed income;
• they turn a lump sum into a stream of future income;
•  lifetime annuities guarantee to pay an income for as long as you are alive, no matter how long you live;
•  when you die, payments stop, unless you have chosen a joint life annuity, a guaranteed payment period or a value protected (money back) annuity.

The advantages of Annuities

• annuities are the only policy that guarantees an income for the rest of your life, no matter how long you live;
• they provide a high level of guaranteed income;
•  they are simple to understand and give security and peace of mind;
•  annuities are based on the concept of mortality cross subsidy so they insure you against outliving your assets.

Background to annuities

Annuities are one of the oldest financial contracts and their origins can be traced back to Roman times, when policies known as ‘annua’ promised to pay income for a fixed term, or possibly for life. Annuities were available in the Middle Ages, the most famous of which were known as ‘tontines.’ These policies paid an income for life, and every year the payouts for those who died were spread amongst the survivors.

The last surviving policyholder received the remaining capital. Thus, they combined the concept of insurance with an element of gambling. During the 1700s, several governments including England and Holland sold annuities in lieu of government bonds.

In the 19th century annuities were used to provide income for elderly relatives or employees. Today they play a very important part in retirement planning, and the annuity market is worth over £6 billion.

Pensions Simplification

New rules surrounding pensions came into effect in April 2006 and introduced some new options for annuities and pension drawdown..

The changes at a glance

• All pension schemes, including protected rights and AVCs will be able to pay a tax free cash sum (now called pension commencement lump sum) of 25 per cent of the fund before an annuity is purchased;
• there is a new annuity option called the "value protected" or "money back" annuity;
• there is a new name for pension drawdown, called taking an ‘unsecured pension;’
•  after the age of 75, individuals can continue with a limited form of drawdown, called Alternatively Secured Pension or ASP.                          

The "Open Market Option" - getting the best annuity

The annuity market is very competitive and rates differ between annuity providers. You can substantially increase your pension income by purchasing your annuity from the company which pays the most income.

This is called "exercising the Open Market Option." It costs nothing to take advantage of this option and new rules introduced by the FSA mean that insurance companies must tell you about this option. You can check out the best annuity rates by using the Annuity Calculator.

Annuity options

Annuities have a number of important and valuable options that allow you to tailor the income to meet your personal circumstances. The most important options are as follows:

Single or joint

A single life annuity pays a high level of income, but stops when you die. If you are married, it is usual to have a joint life annuity. This means that annuity payments will continue to your partner if you die first.

You can choose how much income your partner will receive after you have died. For example, a 50 per cent joint life annuity means that when you die, your partner will receive 50 per cent of your pension until he or she dies.

Guarantee periods

You can purchase a 10 year guarantee to ensure that if you die soon after annuity purchase, your spouse will continue to receive your annuity income for 5 or 10 years. Buying a guarantee will reduce the income payment slightly, but this is a valuable option if you want peace of mind.

Annuity Protection - Money Back Annuities

It is also possible to buy a ‘money back’ or ‘value protected’ annuity. If you die before reaching age 75 and you have not received a certain amount of annuity payments by that time, the balance will be paid as a lump sum.

This lump sum has the rather clumsy name of ‘an annuity protection lump sum death benefit’ and is taxable at 35 per cent. Supposing you purchased an annuity for £100,000 that paid an income of £7,000 per annum and you died after 5 years, having received £35,000 in income.

The difference between the capital invested and the total of annuity payments received would be £65,000. Therefore, after deducting tax of 35 per cent, a lump sum of £42,250 would be paid to your family. At present the Annuity Protection option is only offered by a small number of annuity providers, mainly those which offer enhanced annuity rates, such as Just Retirement.

Escalation

A level annuity pays the highest income at the start and does not increase in the future, whereas an escalating annuity starts at a lower level, but increases each year.

The increases can be constant, for instance, increasing by 3 per cent each year, or the increases can be linked to changes in the retail price index, more commonly known as index linking.

It is only natural to want the highest income, but you shouldn't forget the effects of inflation. An increasing annuity may start lower, but it will pay out more income in the future.

Don’t underestimate the corrosive effect of inflation. With inflation at just 2 per cent pa, a fixed pension will lose one third of its purchasing power after 20 years.

Enhanced Annuitites

If you are in poor health or have a life reducing medical condition, it is worth checking with an IFA whether you are eligible for an ‘enhanced’ annuity. This will pay a higher income because a medical condition which is likely to reduce your lifespan means that the insurance company probably won’t have to pay out for as long as for someone in good health.

There are three basic types of enhanced annuities:

Lifestyle annuities

These take into account certain behavioral and environmental factors, as well as medical factors to determine if you have a reduced life expectancy.

Any factor that may reduce life expectancy may be considered. These include smoking (10 cigarettes, or the equivalent cigars or tobacco, a day for the last 10 years), obesity/high cholesterol, hypertension/high blood pressure and diabetes.

Impaired life annuities

An impaired life annuity pays an even higher income for those who have significantly lower life expectancy. The insurer will require a medical report from your doctor (no need for you to have a medical examination).

Medical conditions such as heart attacks, heart surgery or angina, life threatening cancers, major organ diseases, such as. liver or kidney and other life threatening illnesses such as Parkinson's and strokes will be considered. Just Retirement will consider up to 1,500 difference medical conditions when assessing annuitants for eligibility for impaired life annuities.

Immediate needs annuities

These are designed  for an elderly person who is terminally ill and about to enter a nursing home for the final years of their live. A lump sum payment will buy an immediate needs annuity which guarantees payment of the elderly person’s care until they die. These annuities are expected to normally pay out for around 2-3 years only.

With profits annuities

With profit annuities pay an income for life, but the insurance company invests your pension fund in a with profits fund, (rather than fixed interest securities as happens with a conventional annuity).

A with profits annuitant therefore benefits from any future profits, but will also share in any of the losses in the with profit fund. You have to choose an ‘assumed bonus rate’ of say 3, 4, or 5 per cent.

As a rule of thumb, if the bonus actually paid by the insurance company exceeds the ABR, your income will rise. If it is less than your chosen ABR, your income will fall.

This means that you have to be prepared to receive a fluctuating income, so they are only suitable for people who can afford to take this risk.

With-profits annuities have the normal annuity options, namely single or joint life, and a choice of guaranteed periods and payment frequencies.

Disadvantages of with profit annuities

• future annuity payments will fall if the with profit bonuses are lower than expected;
• increases in future life expectancy can be passed on to the policyholder through reductions in future bonuses;
• with-profits annuities are more complex products, but provide investors with the potential for income growth if they are prepared to shoulder the additional risks.

 For further information contact a specialist annuity adviser.

Flexible annuities

A flexible annuity combines the advantages of an income for life with the advantages of a certain amount of flexibility and control over income payments, investment options and death benefits.

When a traditional (non-profit) annuity is set up, the options selected cannot be changed a later date even if your circumstances change. For instance, if it is a joint life annuity and your partner dies first, the annuity cannot be re-priced to reflect the higher rates for a single life annuity.

But a "flexible annuity" gives you income flexibility, investment control and choice of death benefits.

There are now some new income drawdown products, for instance, the income plans from Living Time which although not annuities have many of the features and advantages of a Flexible Annuity.

There are only a few flexible annuities on the market, from Prudential and London & Colonial. However, they are extremely complex, so be sure to take independent financial advice from an annuity specialist before entering into one of these arrangements.