ANNUITIES

How do they work?

Buying an annuity means using your pension fund to buy a guaranteed income (an “annuity”) for life. A proportion of your fund can normally be taken as a tax-free lump sum with the balance purchasing an annuity. The maximum amount of tax-free cash is 25% (or the equivalent of under Defined Benefit schemes), unless you have some sort of Tax-Free Cash protection in place.

As of April 2015, you no longer need to buy an annuity (or an alternative retirement product) with your pension funds, as it is possible to take the whole fund as a cash sum (subject to tax charges). You will still be able to purchase an annuity, and changes since April 2015 mean that joint-life annuities can offer more flexibile death benefits, thus making them slightly more attractive than before. For changes that came into effect in April 2015, jump to the following section.

The amount of pension income you can expect to receive depends on several factors prevailing at the time of annuity purchase:

Age: generally, the older you are (and your spouse if a widow or widower’s pension is required) the higher the level of income you may expect to receive.
Health: if either you or your spouse does not enjoy good health there are providers that can offer enhanced levels of annuity.
Annuity rate: The level of annuity (the “rate”) offered at purchase date is influenced by current and future expectations for interest rates, as determined by the provider. The rate determines the total amount of pension that can be purchased. The higher the rate, the larger the pension that can be secured from your pension fund. In recent years annuity rates have fallen and this has resulted in a general reduction of the level of annuity secured for a given sum. Increased life expectancy also affects annuity rates as product providers now expect to pay annuities for longer.
Value of your pension fund: The greater your fund the more guaranteed income you will be able to secure. Naturally, where you elect to take part of the fund as a tax free lump sum this will reduce the level of income attainable.
Extra features: Benefits may be added where they are of particular interest to you. However, their inclusion will reduce the level of annuity. For example, a pension with a level income will provide a higher income initially than one set up to increase every year. Any features must be selected at outset, as it is not permitted to add these on at a later stage. The most common benefits available are:

Spouse’s pension so that income continues to be paid to your spouse in the event of your death.
Annual percentage increase to the level of pension income, providing a degree of “inflation proofing”.
Guarantee to pay the annuity for a minimum period (e.g. 5 or 10 years).

Choice of Provider: When considering annuity purchase, it is important to remember that you do not always need to purchase the annuity from the company used to build up the fund. This company may not offer the best annuity rates, as the level of pension will vary from one provider to another. In recognition of this the majority of providers allow transfer to an alternative annuity provider at little or no cost. This is known as the “open market option”. It therefore makes sense to shop around for the best possible pension.
Timing of purchase: The annuity rates prevailing at the date of purchase determine the amount of annuity you will receive and the use of the open market option may secure a better annuity. Annuity purchase can now be deferred indefinitely. Previously, it was mandatory to purchase an annuity with pension funds at the age of 75.
What happens when you die? If you selected only a single life annuity at outset the payments will cease upon your death. However, where you have selected other benefits, for example a spouse’s pension, further payments may be continued, according to the terms and conditions agreed. These options are fixed from the outset, and cannot normally be altered to adapt to changes in your personal circumstances.

The Taxation of Annuities

The income from an annuity is added on top of other income that you may be in receipt of, and will be subject to income tax at your highest marginal rate - or not at all if you still fall below the basic rate tax threshold. When tax free cash from a pension plan or scheme is taken at outset and not utilised, it may be included in the value of your estate and therefore increase any potential inheritance tax charge.

Different types of Annuity

Conventional Annuities

This is the “traditional” method of converting a pension fund into an income for life. A basic conventional annuity is one that pays out an income for the life of the annuitant (the person purchasing the annuity) and ceases on death, unless any optional features have been incorporated, as described above. By buying a conventional annuity you will be guaranteed an income for life, irrespective of any subsequent movement in the investment markets.

When looking at conventional annuities there are two further areas that must be considered:

Enhanced annuity rates. It is sometimes possible to obtain higher annuity rates than are generally available where the annuitant’s medical history, former occupation or lifestyle are deemed by some insurers to reduce life expectancy. It is therefore important that any reason that may qualify you for an enhanced rate is established.
Guaranteed annuity rates. In the past some pension contracts provided for a guaranteed level of pension income at retirement. Recent economic conditions have meant that in many cases the level of guaranteed income is higher than could be obtained by purchase of an annuity in the open market and hence these can represent particularly good value. These guarantees tended to apply to policies set up before 1988, known as “Retirement Annuity Contracts”. If in doubt, contact your financial advisor or the insurance company who administers the contract.

Advantages (conventional annuities):

You are able to take the full tax-free cash sum entitlement at outset. Income is paid at least for life, and longer if relevant features were selected at outset. The benefits selected are guaranteed and income is not affected by future falls in interest and or annuity rates.

Disadvantages (conventional annuities):

You lose ownership of the fund in exchange for the purchase of the annuity. Because of this, in the event of early death, you may not get value for money – although this may be offset by the provision of a spouse’s pension.
Annuities are inflexible to the extent that once purchased, they can’t be altered to reflect changes in personal circumstances. Where a level annuity has been selected, inflation may erode its value.

For whom might conventional annuities be suitable?

Such contracts may be suitable for those who have a need or desire for a predictable, guaranteed annual income level.

Purchased Life Annuities

Generally, Purchased Life Annuities are less popular than other financial products, but they can still be useful in certain circumstances. If someone needs to secure a known stream of income for life, or someone wishes to invest a capital sum with as little risk as possible, then a Purchased Life Annuity is an unexciting but safe option.

Investment Linked Annuities

Investment linked annuities work on similar principles to those of conventional annuities. The difference is that the level of income is determined, at least in part, by the performance of the underlying funds, rather than by guarantee at outset. Consequently the level of income will depend upon investment returns. Investment linked annuities are generally known as either with profits annuities or unit linked annuities.

A with profits annuity provides you with a regular income for life. Income is derived from two elements:

a guaranteed minimum income
any annual bonuses paid which, once added cannot be taken away.

Usually you will be asked at outset to select an “anticipated” or “assumed” future bonus rate, for example between 0%-5%. This will in turn determine the actual level of income initially paid. Bonuses actually paid reflect the investment performance of the assets within the with profits fund and, as such, cannot be guaranteed. Thus, if bonuses actually paid fall short of the “assumed” rate, your income could fall. An element of security is added however, due to the way with profits funds “smooth” returns to reflect the ups and downs of investment markets.

A unit linked annuity provides an income directly dependent on underlying investment returns and, in most cases, you select an “anticipated growth rate”. However they offer no minimum guaranteed income or any protection given by “smoothing”. Units are bought in the fund(s) selected at the start of retirement. Income is generated each month by cancelling enough units to pay for that installment. The amount of units cancelled will vary depending on their underlying value and the unit price fluctuates with stock market variation. They reflect directly the performance of the underlying assets (usually equities). For this reason they are more volatile and represent a higher risk than the with profit alternative. Conversely, they provide the potential for higher income in future reflecting good investment performance. Income can go up or down depending on investment performance.

Advantages (investment linked annuities):

You are able to take the full tax-free cash sum entitlement at outset.
Income is paid at least for life, and longer if relevant features were selected at outset.
They offer the potential to improve retirement income through future investment growth.
(with profits only) The guarantees implicit in most with profit annuities afford a degree of security as to minimum income level.
Investment linked annuities can offer flexibility to alter income in line with circumstances, for example by changing the assumed future growth rate, converting to a conventional annuity or, in the case of a unit linked annuity, switching between a range of investment funds. Note: It is important to check the individual product provider’s contract, as not all will offer these features.

Disadvantages (investment linked annuities)

You lose ownership of the fund in exchange for the purchase of the annuity. Because of this, in the event of early death, you may not get value for money – although this may be offset by the provision of a spouse’s pension.
Other than any contractual guaranteed minimum income, there is no guarantee as to future income levels generated.
(with profits only) The “assumed” future bonus rate will affect the level of income payable, both at outset and in the future and, if the assumed bonus rate is set too high, future income may fall.
(with profits only) The cost of guarantees implicit to with profit annuities may limit potential returns.
(unit linked only) Income payments are subject to fluctuations and future payments may be less than the starting annuity. It should be noted that the higher the assumed growth of the fund, the greater the level of investment risk and consequent effect on income levels.
Charges for investment linked annuities are generally higher than a conventional annuity as they are more complex to administer.

For whom might investment linked annuities be suitable?

For those whose other retirement income is already secure, perhaps from a final salary pension scheme, or who have other assets.
For those who can afford to take a degree of risk with their retirement income and are attracted by the possibility of improving future income via continued exposure to stock markets.

Fixed Term Annuities

Since 2006, new flexible types of annuities have emerged. These hybrid plans typically offer a guaranteed pension for a fixed period of years (usually five years, but can be for longer or shorter periods of time). This means that you are not locked into a contract for life, but can review your options every few years.

Such plans generally require you to accept some level of income risk, and a certain proportion of your capital remains at risk in order to provide the guarantee. The degree to which your capital at risk varies from plan to plan, as many plans available on the market operate in different ways.

For instance, if you require all your initial capital to be preserved at the end of a five-year time, this will logically imply that the pension you receive will be lower than if you are prepared to accept a degree of risk to your capital (I.e. you receive back less than the original purchase price of the plan).

These contracts are often referred to as Variable Annuities, or Third Way Annuities. The later name derives from the fact that many of these plans combine features of conventional annuties (such as guaranteed income), but with some of the flexibility of Drawdown Pension plans.

Despite the flexibility, like most financial products they are not without risk. For instance, you could take out a five-year fixed-term annuity, and find that annuity rates are now worse, and a conventional annuity may have been a better choice.

In general, these plans are probably more suitable for individuals with larger pension funds or other sources of pension income, and less suitable for those with smaller pension funds, for whom the conventional annuity is still probably the most appropriate route to go down.

Secured Income

Since 06/04/2006, annuities in payment have been offically refered to as 'Secured Income'. This is more of a technical term, and not widely understood. It refers to the fact that the benefits are fixed and guaranteed for life (or for a more limited period). A pension can be described as 'secured' if it derives from:

A promise from a pension scheme e.g. a defined benefit scheme (Final Salary Scheme), or
An annuity purchased from an insurance company.

This new distinction is used to differentiate between pension income that is 'secured' and types of pension income that is 'unsecured' - i.e. income from pension contracts that remain fully invested, such as Drawdown Pension contracts.

When you are in the position of needing to purchase an annuity, it is worth remembering that there is currently more choice than ever before regarding the types of annuity that can be purchased. Not every type will be suitable, but it does pay to 'shop around' instead of taking whatever your pension provider offers you. The difference between what the best and the worst annuity providers will offer can be quite surprising. If you are unsure about the options, seeking independent financial advice can help you to maximise the income that will be genereated from your accumulated pension funds.

April 2015 Changes

Subtle, yet significant rule changes were made in April 2015 in order to bring the treatment of annuities into line with Drawdown Pensions. However, you should be aware that these only apply to annuities purchased AFTER April 2015 and do not apply to existing contracts purchased before that date.

The most significant change is that joint-life annuities can be paid out to any beneficiary (i.e. any family member) rather than a dependent (usually the spouse).

When an annuitant dies under the age of 75 with a joint-life or fixed-term annuity, and payments to beneficiaries will be tax-free.

If an individual under 75 dies with Drawdown Pension funds, any annuity purchased by a beneficiary can be made tax-free.

Note: Although joint-life annuities can now be passed to any beneficiary upon the first death, they will cease upon the death of the beneficiary, unlike Drawdown Pensions, which can be passed from beneficiary to beneficiary.

Some other changes

The 10 year cap on guaranteed payments has been removed, and payments can be guaranteed for any period of time, subject to agreement with the annuity provider. As before, the longer the guarantee, the lower the initial level of income.

NOTE: This document is intended to provide a brief overview of the subject. It should not be read as a recommendation to use any particular product, as it does not take into account individual circumstances and attitudes.

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