A Pension Annuity is an investment which guarantees, regardless of how long you live, an income for life. In the UK there are two basic types of annuity, a compulsory purchase (pension annuity), and a voluntary purchase (purchased life annuity). Both these types of annuity pay a guaranteed income by turning a lump sum into an income stream, which are paid as long as you live. When you die, the payments stop, unless you have chosen a joint life annuity or a guaranteed payment period. Annuities have the advantage of being fairly simple to understand. It is estimated that the annuity pension market stands at £6 billion per annum.
After paying your pension all your working life, your pension company is left with a lump sum, which they will invest in an annuity. You do not have to accept their proposal and you are able to shop around for the best option available to you. Using this Prudent Minds guide will hopefully help you understand the annuities market a little better.
How Annuities Work
If you were given a lump sum on retirement, which you knew had to last until you died, you would be faced with a dilemma. Withdraw too much per month and you wouldn't have enough to last until you die; withdraw too little and you leave without spending your hard earned cash. If you invested your money cautiously, you may not receive as much as you would like, but invest riskily, and you may loose your income.
Annuities convert the lump sum capital into an income by providing a high level of guaranteed income, for life, with no risk, by investing in fixed interest investments and applying what is known as a "mortality cross subsidy"
When you invest in an annuity, the insurance company uses their measures to estimate your life expectancy, and then uses this to calculate the level of payments they will make to you. Obviously, some people live longer than expected, and so the company loses out, however, it makes a gain where people die earlier than expected. The company uses the profit made from those dying earlier to pay those living longer - the mortality cross subsidy.
So, put simply, an annuity is calculated by taking the amount of money you have invested (plus the interest) and dividing it by the number of years you are expected to live.
Where you know there is a medical condition which may reduce life expectancy, there is the option of an enhanced annuity. This would mean a higher income is received because an allowance is made for the reduced life expectancy. These come in three types:
Lifestyle Annuity - taking into account environmental, behavioural and medical factors (this may include smoking over a long period, obesity, high blood pressure etc)
Enhanced Annuity - pay out more than Lifestyle Annuities, but not as much as:
Impaired Life Annuities - For those with a medical condition which would severely reduce their life expectancy, such as heart conditions, cancer, major organ disease etc
What are your Annuity Options?
Annuities, in general, are not flexible, and cannot be changed, transferred or surrendered, so it is vitally important that you make the best choices available for you and your family.
Joint or Single Annuity? A single annuity pays a high level of income, but will stop when you die, whereas a joint annuity continues to your partner, for the term of the annuity, should you die first, You can make choices about the percentage of the annuity your partner will receive. For example, a 50% joint life annuity gives your spouse 50% of your pension after your death. There are guidelines as to who you can name in a joint annuity, but they must be a legal spouse at time of retirement, legal spouse at time of death or a legal dependant at time of death.
Guarantee Periods Where an annuity is guaranteed for a specified period, the annuity will continue to be paid for the period, regardless of when you die. So, if you bought an annuity today, without a guarantee period, and died tomorrow, your money is gone, and your estate would receive nothing. However, if a guarantee period is in place, then your estate will continue receiving the annuity pension for that guaranteed period/
Annuity Protection There are only a small number of insurers who offer this option, and so it is well worth looking into whether their annuity pensions are a good option. The protection option guarantees that, if you die before 75 years of age, and you have not had a specified percentage of your annuity payments in that time, the balance will be paid in the form of a lump sum, which is taxable at 35%.
Escalation Annuities can be level, or escalating. A level annuity means that your income is static and remains the same over the period of your retirement. An escalating annuity increases each year. When considering this option you need to consider the "buying power" of your money. If inflation increases, but your annuity is static, the income you receive will buy less and less over time. Should you choose an escalating annuity, you may keep up with rising costs, but this would depend on the type of escalation and the rise in cost of living.
Overlap If you have both a joint pension annuity and a guarantee period, you have the option of an overlap. This means that your spouse’s pension would start immediately after you die and if guarantee payments are due they would run alongside the spouse's pension. If you have no overlap, the spouse’s pension would not start until after the guarantee period.
Types of Annuity
Enhanced Pay out more where life expectancy is shorter. See above for more details.
With profits combine the income for life with investing in the stock market. This means they have the potential of growing in size and hopefully buffer the effects of the rising cost of living. They can, however, like all investments, fall. They are more complex than other options.
Fixed Term This is an investment with a draw down plan which provides a guaranteed income for a set number of years, or until you reach 75. At the end of the guaranteed period there would be a maturity payout which can be reinvested.
Flexible combines the advantage of your income for life with a certain amount of control over income payments, investments and death benefits.
Purchased Life Annuities converts a capital lump sum into an income. They are similar to pension annuities, but you invest your own money rather than in a pension fund.
If you have been investing in a company pension, stakeholder pension, or other type of pension, the money paid in will be invested in an annuity when you retire. This guide will hopefully have helped you understand your options, but you must take advice from an FSA approved advisor before making your final decisions.