An annuity is effectively the exchange of a lump sum of capital in return for a regular income.
In pension terms, you will normally be entitled to 25% of your pension funds as a tax free lump sum. The remaining 75% is then used to provide a regular income. There are a number of options you need to carefully consider when deciding how to structure an annuity, which include:
•Single or joint life
•Level or escalating income
A single life annuity will cease on the annuitant's death (notwithstanding any outstanding guaranteed period). Many married people will need to ensure that their spouse is provided for should they pre decease them. This is done by building a widow or widower’s pension in to the annuity calculation (typically 50% or 2/3rds of the main annuitant’s income). A joint life annuity will be lower than a single life annuity because of the risk to the annuity provider that they will need to pay the annuity for a longer period of time. The appropriate level of survivor’s annuity will depend on a number of factors such as other pensions, income from other assets and income requirements should the main annuitant die first.
You also need to decide whether your annuity should have level payments, or whether they should increase each year. Escalating annuities (which typically increase by 3% or the retail price index) ensure that you income rises each year to help offset the effects of inflation. However, a level annuity will usually offer a 35-50% higher starting income, and an escalating income will take several years to catch up. You therefore need to carefully consider the most appropriate structure for your own circumstances.
A guaranteed period provides a minimum guaranteed period that the annuity will be payable for, in the event that the annuitant dies prematurely. A guaranteed period of 5 or 10 years can provide peace of mind that a pension fund built up at great expense over a number of years will at least provide some value to beneficiaries in the event of early death. This is typically inexpensive to build in to an annuity in comparison to either a joint life annuity or escalating income.
Enhanced annuities are available to those who may potentially have a reduced life expectancy because of either pre existing health conditions (cancer, heart problems etc) or lifestyle (i.e. smoking). Standard annuity rates are based on a combination of age, gender (men will typically receive better annuity rates than women because of a lower life expectancy) and gilt yields. It is usually necessary to provide details of pre existing medical conditions to an annuity provider to enable them to assess the level of enhancement they are prepared to offer.
Conventional annuities offer a guarantee with regards to the security of the income that will be paid for the lifetime of the annuitant. They are therefore ideal for those who, having built up a pension fund they will rely on for life, do not wish to take any risk with their future income.
However, they are inflexible, and all of the decisions need to be taken at the time the pension fund is converted in to an annuity. For example, someone in good health at the time they purchase an annuity cannot then obtain an enhanced rate if they are later diagnosed with a medical condition that would have qualified for an enhanced annuity. If an escalating income is chosen at outset, it cannot be altered to a level income in the future. If a single life annuity is chosen, it cannot be altered to a joint life in the future.
Therefore, those who are prepared to take some degree of risk with their future income have more flexible options available to them.
With profit annuities offer a more flexible option than a conventional annuity. The annuitant chooses a single or joint life and guaranteed period in the same way as a conventional annuity, but unlike a conventional annuity they do not choose a level or escalating income. Instead an Anticipated Bonus Rate (ABR) is selected. Government legislation allows ABR’s of between 0% and 5%, but the majority of annuity providers do not allow this level of flexibility within their own contracts. The level of ABR chosen influences the starting level of income received i.e. the higher the ABR the higher the starting income. If future bonus levels match the ABR selected the income remains constant. If bonus levels exceed the ABR income rises, and if bonus levels are lower than the ABR income falls.
With profit annuities allow the annuitant to change the ABR at selected times, which means that those with varying income needs can benefit from the flexibility this affords them. For example, a 60 year old male may well have more need for income from their pension for the next 5 years prior to the start of their State Pension than they will do thereafter. As such they may decide to use a higher ABR for this period to maximise their income, and then reduce the ABR (and income) at age 65 when they start to receive their State Pension. Many people like the idea of an escalating income, but are not prepared to accept the lower initial income necessary to facilitate this through a conventional annuity. Therefore they may decide to take a level of ABR that creates the same starting income as a conventional annuity with level payments in the hope that bonus rates will be sufficiently high enough in the future to provide a rising income. Of course there is the risk that if bonus rates are lower than required, then future income could actually fall.
With profit annuities also allow the annuitant to convert to a conventional annuity in the future (something that is not permitted the other way from a conventional annuity to a with profit annuity). This has to be done with the same provider with whom the with profit annuity is held.
Investment linked annuities work on a similar basis to a with profit annuity, but rather than select an ABR to determine both initial and future income, instead it is the underlying investment returns that determine this.
There is the potential for income to rise in the future if investment returns are good, but there is also the risk that they could fall if investment returns are poor.
Temporary annuities enable the annuitant to select a level of income from their pension fund for a fixed period of time, typically 5 years. The annuity provider will then use part of the pension fund to secure this income, and will provide a guarantee as to the value of the remaining fund at the end of the temporary annuity period.
At this point the annuitant can either purchase another temporary annuity, or select a conventional, with profit annuity, unsecured pension etc.
Temporary annuities enable the annuitant to defer the purchase of a lifetime annuity, which could be beneficial should they subsequently become eligible for an enhanced annuity.
Choosing the right option at retirement is an important decision because, in many circumstances, the decision taken cannot be changed in the future.