Poor advice from pension companies and a fundamental lack of knowledge about differing annuity categories means many people on the brink of retirement might miss out on much higher levels of retirement income – Financial Times Jan 2009

What Is An Annuity?

An annuity is an income for life provided by an insurance company in exchange for a pension fund or any lump sum. The bigger the pension pot, the bigger the income will be.

In the UK, there are basically two types of annuity, pension annuities and purchased life annuities.

All annuities 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.

There are many variants on these two basic forms of annuity – the most common of which are described lower down this page.

It is however, vitally important to be aware of the Open Market Option, as by taking advantage of this change in the rules you may be able to significantly increase the level of income you receive from your pension pot. 

The Open Market Option

Recent changes in pension regulations have heralded the introduction of The Open Market Option. This new ruling gives those approaching retirement the opportunity to shop around for the best deal on the market from any provider rather than having to accept whichever rates were offered by their pension provider.

This competition in the market has benefited consumers in that rates have become far more competitive as each company competes for your custom.

As Pension Watch are whole of market Independent Financial Advisors we can research the whole of the market on your behalf to find the best annuity rates for you.

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 income, 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.

Annuity Options

Single Or Joint

A single life annuity pays a high level of income, but stops when you die. If you are married it is more usual to have a joint life annuity. This means that when you die, your partner will receive 50% of your pension until he or she dies.

You can choose how much income your partner will receive after you have died. For example, a 50 % joint life annuity means that when you die, your partner will receive 50% of you 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 you annuity income for up to 10 years. Buying a guarantee will reduce the income payment slightly, but is a valuable option if you require peace of mind.

If you select a 5 year guarantee (which is the norm) , and died two years after purchase, your estate would continue to receive an income for the next three years. If you chose a 10 year guarantee, and died after 2 years, the payments would continue for another 8 years.

Annuity Protection – Money Back Annuities

It is also possible to buy money back or value protected annuities. 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 is called an “annuity protection lump sum death benefit” and is taxable at 35%.

If you were to buy an annuity for £100,000 that paid an income of £7,000pa, and you died after 5 years, having received an income of £35,000. Then the difference between the capital invested and the total of annuity payments would be £65,000. Therefore, after deducting tax of 35%, a lump sum of £43,250 would be paid to your family. At present the Annuity Protection option is only offered by a small number of annuity providers.

Single Or Joint

A single life annuity pays a high level of income, but stops when you die. If you are married it is more usual to have a joint life annuity. This means that when you die, your partner will receive 50% of your pension until he or she dies.

You can choose how much income your partner will receive after you have died. For example, a 50 % joint life annuity means that when you die, your partner will receive 50% of you 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 you annuity income for up to 10 years. Buying a guarantee will reduce the income payment slightly, but is a valuable option if you require peace of mind.

If you select a 5 year guarantee (which is the norm) , and died two years after purchase, your estate would continue to receive an income for the next three years. If you chose a 10 year guarantee, and died after 2 years, the payments would continue for another 8 years.

Annuity Protection – Money Back Annuities

It is also possible to buy money back or value protected annuities. 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 is called an “annuity protection lump sum death benefit” and is taxable at 35%.

If you were to buy an annuity for £100,000 that paid an income of £7,000pa, and you died after 5 years, having received an income of £35,000. Then the difference between the capital invested and the total of annuity payments would be £65,000. Therefore, after deducting tax of 35%, a lump sum of £43,250 would be paid to your family. At present the Annuity Protection option is only offered by a small number of annuity providers.

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, eg 3%pa or the increases can be linked to 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 will pay out more income in the future.

Inflation can have a very corrosive effect on the purchasing power of your income. With a rate of 2% inflation pa a fixed pension will lose one third of its purchasing power after 20 years.

Enhanced Annuities

If you are in poor health or have a life reducing medical condition, it is worth checking with us to see if 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 wont have to pay out for as long as someone in good health.

With Profits Annuities

A with profits annuity will pay an income for life, but the insurance company invests your pension fund in a with profits fund. You are then able to benefit from any future profits of the life fund, but will also share in any losses. This means that you have to be prepared to receive a fluctuating income, so this form of annuity is only suitable for those who can afford to take this risk.