Guide to Annuity
"An annuity is a very serious business; it comes over and over every year, and there is no getting rid of it", wrote Jane Austen in Sense and Sensibility in 1811. Annuities are still a serious business today because they are the only financial product that can provide a safe and secure lifetime income for retired investors.
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What is an annuity?
An annuity is an investment that guarantees to pay a secure income for the rest of your life, no matter how long you live. In the UK, there are basically two types of annuities; 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 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 out living 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 last year the annuity market was worth over £6 billion.
How annuities work
In order to understand how annuities work, consider what would happen if there were no annuities. If you wanted an income from your pension fund when you retired, you would have to make regular income withdrawals. However this would create two problems.
How much income?
If you withdrew too little income, you would die without having spent all your money, but you would leave money to pass on to your family. Yet, if you withdrew too much you would run out of money and have to rely on your savings or fall back on your family or the State.
Where to invest?
If you invested too cautiously your income would be lower, but safer than if you had invested in a more risky way, but you might obtain more income if your investments performed well.
Annuities provide the answer
Annuities efficiently convert capital into income by providing a high level of guaranteed income for life with no risk. This is achieved by investing in fixed interest investments and applying a mortality cross subsidy.
Mortality Cross Subsidy
When someone buys an annuity, the insurance company works out their normal life expectancy and calculates the level of their annuity payments. However not everyone lives to their normal life expectancy and the insurance company makes a profit from them. However, the insurance company uses this profit to pay the pensions of those people who will live past their normal life expectancy. This means that those who die before their normal life expectancy subsidise those who live longer than expected.
The new rules for tax simplification came into effect in April 2006 and introduced some new options for annuities and pension drawdown. The new rules also allow individuals to have more flexibility and choice over their retirement income options.
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 "value protected" or "money back" annuities
- there is a new name for pension drawdown - 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 recently by the FSA mean that insurance companies must tell you about this option. You can check out the best annuity rates by visiting websites such as http://www.fsa.gov.uk/tables
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 listed below.
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 50per cent joint life annuity means that when you die your partner will receive 50per cent of your pension until he or she dies.
Most annuities are guaranteed to be paid for a certain period of time. This means that if you die soon after purchasing an annuity, your estate will continue to receive income payments. If you bought an annuity without a guarantee period, and died the day after, your income would stop, and your family would get nothing (or a reduced amount it was a joint life annuity) and the insurance company would make a huge profit. To protect against this unlikely event, you can guarantee that your annuity payments will continue to be paid for period of time. If you select a 5 year guarantee (this is the norm), and died after two years, your estate would continue to receive an income for the next three years. If you had chosen a 10 year guarantee, the payments would continue for another 8 years.
Annuity Protection - Money Back Annuities
There is now a new option called Annuity Protection. 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 per cent. These annuities are also known as "value protected" or "money back" annuities. For example, if you purchased an annuity for £100,000 that paid an income of £7,000 per annum and you died after 5 years, 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.
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. Remember the saying: "Inflation is like sin, every Government denounces it, but they all practice it".
Standard annuity rates are calculated with reference to the average life expectancy for people living in the UK. This is fine for those in good health, but not so good for those who have below average life expectancy. An enhanced or impaired life annuity pays a higher income because an allowance is made for any medical conditions which might reduce your life expectancy. There are three basic types of enhanced 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.
With profits annuities
With profits annuities combine the advantages of an income for life with the advantages of investing in a fund that invests in a range of fixed interest, property and equities. Income from a with-profits annuity is not guaranteed, but policyholders will benefit from any future profits, or share in any of the losses in the with profit fund. This means that your income may fall as well as rise, 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.
The advantages of with-profit annuities
- they combine the advantages of an income for life with the advantages of investing in the stockmarket
- with-profit funds smooth investment returns, ironing out investment peaks and troughs
- they provide the potential of a growing income, with the security and peace of mind associated with annuities
- in the longer term, with-profits annuities should help to hedge against inflation
The disadvantages of with profit annuities
- Future annuity payments will fall if 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.
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. Flexible annuities give you greater control over your annuity. 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. Or if your circumstances change, you cannot alter your income. 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 and if you would like more information please contact a specialist annuity adviser.