What is An Annuity?
Voltaire once famously said…
“I advise you to go on living solely to enrage those who are paying your annuities. It is the only pleasure I have left.”
Hopefully, once you retire annoying Insurance Companies won’t be the only pleasure you have left, but having a reliable income in retirement will allow you to continue to enjoy the things you enjoy most. Purchasing an annuity is one way to provide such an income.
Let’s look at what they are…
So what is an annuity anyway?
An annuity is a contract between an insurance company and an individual which, once purchased, (at retirement) agrees to pay a guaranteed set income for the rest of the individuals life. They are normally purchased with savings accrued through an individual’s pension.
Where are they useful?
If someone is concerned that the savings they have set aside for retirement may run out before the end of their life, an annuity can provide peace of mind by assuring a certain fixed income will continue to be paid to them no matter how long they may live.
Are there different types of annuities?
Yes there certainly are, and choosing the right one to suit your situation should be carefully considered. Here are the most common types you are likely to come across…
Standard or ‘Level’ Annuity
This simply does what it says on the tin, it pays a fixed income for the remaining duration of an individuals life. You can choose them for a single life or join life as desired.
Joint-Life and Value Protected Pension Annuities
If you wish your retirement income to be paid to your surviving spouse, or pension savings be returned to your estate upon your death, then discuss purchasing a Joint Life Annuity or a Value Protection Annuity with your advisor, because with these for example, your spouse can continue to receive an income plus a lump sum upon your death, (less income already paid and 55% tax deduction).
This adds an extra layer of guarantee protection to the standard annuity so that should an individual die before 75, the fund built up will be returned to the estate minus tax and the income that had already been paid out by the annuity.
Enhanced or Impaired Life Annuity
These are known as ‘impaired’ life annuities because they relate to health issues. Certain insurance companies will offer to pay better annuity rates to those who have health problems (because their life is ‘impaired’ by illness or disease for example). The insurance company will have carefully calculated these people are likely to have a lower life expectancy, and therefore they can afford to be more generous with their rates.
The types of people that can qualify for an impaired annuity may be those with histories of cancer, heart disease and other serious health issues (IMPORTANT CAVEAT: You don’t always have to have very serious health issues to qualify for these types of annuities. Many people with relatively light health issues are accepted, so do ask your advisor about them).
Those who are seriously overweight or heavy smokers may qualify for an enhanced annuity (which is virtually the same as an ‘impaired’ one because these lifestyles can seriously affect life expectancy).
It certainly make sense to look into whether you could receive an enhanced or impaired annuity if health issues affect you—again, ask your advisor. It can be a lengthy process to go through, because first your medical background will be thoroughly checked, you will need to undergo extra medical tests, and it is underwritten by the insurers on a case by case basis.
Investment Linked Annuities
There are pros and cons to these types of annuities and they should be considered carefully to match your risk profile and temperament among other considerations. Linking an annuity to stock market investments means there is potential to realise returns from those investments via your annuity income. Therefore your income could increase. However, exposure to the stock market also means that your annuity linked investments could also go down, so it is riskier than buying a standard annuity.
With Profits Annuities
With this type of investment annuity some of the returns are held back in years when profits rise, so that in years when returns are not so good, the profits that had been held back can be added to your income smoothing out peaks and troughs in returns and your income therefore.
You will need to choose an ABR which stands for Anticipated Bonus Rate when you take out one of these annuities. The ABR regulates the amount of income you will be paid linked to the bonus the insurance company declares each year. For example if you choose an ABR of 2% and the insurance company declare a 4% bonus then your income will rise. The opposite is also true. If the company only makes a bonus of 1% available your income will go down if you have chosen an ABR of 2%.
Unit Linked Annuities
With these type of annuities your income will fluctuate depending on how successfully the stocks and shares of the unit linked pension your annuity invests in perform. You are also able to switch between different funds, but doing so will inevitably incur more costs, so it’s worth considering whether doing so will be worth it.
If you prefer managing the investments yourself, you could choose a Self Invested Unit-Linked Annuity, but only if you are not afraid of exposing your retirement income to risk and are happy living with this level of exposure to risk.
NOTE: Unit Linked types of annuities are for experienced investors who have a bold attitude to risk and are able to cope with fluctuations in monthly income (and have alternate income to cope) and are not afraid of volatile markets. Definitely not for those who just wish to retire quietly, content that steady payments drop into their bank account efficiently every month without fuss.
Purchased Life Annuities
You buy these type of annuities with a cash lump sum, not with money accrued from your pension pot. You are limited to buying a standard type of annuity not linked with investments.
The main benefit these types of annuities have is that on the event of your death, any remaining capital can be repaid to the estate. Of course if by the time you die, you have used all of that capital then your heirs will not receive any money at all.
Do I have to use all of my pension savings to buy an annuity?
No, you may take up to 25% of your pension savings in a tax free, cash lump sum at retirement. The rest must be used to provide yourself with an income that is taxed, and generally most people choose annuities.
Does my annuity cover only me? What about my spouse?
No, you can purchase joint-life annuities so that any surviving spouse will receive the annuity income after you die and generally continue until their death. Some pay to surviving children too but only for a limited time. Joint Life Annuities cost more to purchase than single life ones and it’s wise to discuss the pros and cons associated with choosing one with your Financial Advisor.
Do I have to take just a set amount of income each month? Can’t it increase over time?
You may choose an inflation linked annuity which increases each year to ensure your income is matches the increase in living costs associated with rising inflation. However, these types of annuities are more costly to purchase in the first place, and give you and income that starts lower too when you begin drawing it, so getting advice on whether or not buying an inflation linked annuity will work for you is well worth considering.
There we are then, a pretty straightforward guide to what an annuity is. Of course the devil is in the detail, and they are complex financial instruments, so if you have questions concerning anything I have discussed above, please do give me a call. It’s free from a landline on 0800 321 3508 or call my mobile on 0757 679 1009.
Alternately fill out the form below…
