What is an Annuity?
In the UK there are basically two types of annuities; pension annuities (compulsory purchase) and purchased life annuities (voluntary purchase). The pension annuity is by far the most popular and is discussed at length below. All annuities share the following characteristics:
- An investment which pays a high income for the rest of your life no matter how long that is
- Converts a lump sum into a stream of future income.
- Enhanced rates are available for those in poor health
- When you die, payments stop, unless you have chosen a joint life annuity or a guaranteed payment period
- Payments remain level or increase each year
What are the Options?
Everyone is different and annuities come in all shapes and sizes. There are lots of extra features tat you can add to your annuity to tailor it to your personal circumstances.
Standard Or Enhanced Annuity
Standard annuities assume that you are in good health but if you have below average life expectancy, you can apply for an enhanced annuity which will pay a higher income at the outset
Single or Joint Annuity
A single life annuity pays a higher level of income but stops when you die. If you are married, in a civil partnership, or cohabiting you can choose to have a joint life annuity which will continue to your partner if you die first. You can choose how much income your partner et if you die first.
A guaranteed period ensures annuity payments are made for a minimum term even if you and your partner die during that period. If you selected a 5 year guarantee and died after 2 years, income would continue to be paid to your dependants for a further 3 years
Level or Escalating Payments
A level income pays the highest income from the outset, but will never increase and is likely to lose its buying power as you get older. A income that guarantees to increase each year, 3%, 5% or RPI for example, will start at a much lower income level but increase over the years.
Annuities are usually paid monthly but can be paid quarterly, half yearly or annually. You can choose to have payments made at the beginning (in advance) or at the end (in arrears) of the chosen payment period. The longer you leave it before you receive the first payment, the higher the income at the start.
What is an Open Market Option?
When you retire you do not have to arrange your annuity with the company you have invested your pension with. You can substantially increase your pension income by purchasing your annuity from the company which pays the highest income. This is called “The Open Market Option”.
What are Investment Linked Annuities?
Investment linked annuities combine many of the advantages of traditional annuities such as an income for life, with some of the advantages of drawdown such as and the option to invest in the stock market.
Most flexible annuities have the following advantages:
- Potential for future income growth – By investing in the stock market flexible annuities have the potential to pay a higher income in the future. However if investment returns are lower than expected future income could be less
- Income flexibility – Income can be taken within an upper and lower limit and may be changed from time to time
- Income guarantees – Normally there is an option for a minimum level of income to be guaranteed
- Control over investments (except with-profits) – There is a wide range of investment options to suit your attitude and capacity for risk
- Choice of death benefits – The normal annuity options for joint life income, income guarantee periods and value protection are available
The most well-known annuity in this group is the ‘With-Profit Annuity’ which as its name suggests is invested in a with-profits fund.
Fixed Term Annuities
A Fixed Term Annuity (FTA) is an investment within a drawdown plan which provides guaranteed income payments for a set number of years. At the end of the term there will be a guaranteed maturity payout which can be reinvested in an annuity or a drawdown plan.
The policy can be set up on a joint life basis and with a guaranteed income period or value protection option. This means that on death before the policy matures, income payments will continue to a surviving spouse / partner or a lump sum less 55% tax can be paid depending on the options chosen.
The Advantages and Disadvantages of Drawdown & Annuities
- Income is known at outset, guaranteed and secure
- Simple and easy to understand
- Not affected by downturn in investment markets
- Income is payable for life, however long that is
- Once set up, they cannot be altered
- Existing annuity rates are low
- Level income will lose its buying power over time
- Can be poor value if annuitant dies young
- Potential for growth as the remaining fund is invested
- Income levels can be very flexible to suit needs
- Remaining pension fund can be passed to beneficiaries on death
- Retain investment choice and control
- Income and fund value are not guaranteed and can go down
- Can be more complex and is likely to need advice
- The pension fund may run out if too much income is taken or the fund drops
- Drawdowns will need regular reviewing by a professional adviser