Annuities are a serious business because once bought you cannot change your mind and switch to another provider. In addition, increasing longevity means that your annuity will have to last you for possibly 20 or even 30 years of retirement, making decisions around inflation proofing your income very important.

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 then guarantees to pay you an income for the rest of your life via the annuity.

Different types of annuity

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

  • Pension annuities (compulsory purchase)
  • Purchased life annuities (voluntary purchase).

All annuities share the following characteristics:

  • They pay a 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 one of the only products that guarantee an income for the rest of your life, no matter how long you live;
  • 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.

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 and new rules introduced by the Financial Services Authority mean that insurance companies must tell you about this option.

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 secure level of income, but stops when you die. If you are married, it is possible 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% joint life annuity means that when you die, your partner will receive 50% of your pension until he or she dies. But be aware that buying a guarantee will reduce the income payment slightly.

Guarantee periods

You can purchase a five or 10 year guarantee to ensure that if you die soon after annuity purchase, your spouse will continue to receive your annuity income for five or 10 years.

Buying a guarantee will reduce the income payment slightly, but this is a valuable option if you want peace of mind.

If you select a five 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.

Annuity protection

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%.

Supposing you purchased an annuity for £100,000 that paid an income of £7,000 per annum and you died after five 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%, 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.

Escalating annuity

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% 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 should not forget the effects of inflation. An increasing annuity may start lower, but it will pay out more income in the future.

The corrosive effect of inflation should not be underestimated. With inflation at just 2% annum, a fixed pension will lose one third of its purchasing power after 20 years.

Enhanced annuities

If you are a smoker, in poor health or have a life reducing medical condition it is worth checking with an IFA to ascertain 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 insurer probably will not 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 behavioural 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 (there is 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.

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 life. 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 two to three 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’ (ABR) of say three to 5%.

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.

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 at 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 only a few flexible annuities on the market. However, they can be complex and so independent financial advice should be sought from an annuity specialist before entering into one of these arrangements.