Annuities

What is an annuity?

An annuity is purchased with a lump sum and pays a regular income for the rest of your life, although shorter “term” annuities are also available. Normally annuities are purchased by pension pots. Annuities can be traced back to the Roman era when “annua” promised a stream of payments for a fixed period of time, or for life, in return for a single premium payment. Modern annuities offer investors a choice of income levels, benefits and how much risk they want to take with their savings.

Do I have to buy one?

Until the end of the current tax year (April 5, 2006) it is compulsory to buy an annuity if you have a money purchase pension scheme, including a personal pension, and you need to use at least three quarters of your fund to buy an annuity before you reach 75. You can buy the annuity offered by your existing pension provider or go elsewhere. Those who have not made formal pension provision can buy a purchased life annuity.

From April 6, instead of buying an annuity, you will be able to draw an income directly from your fund after you have reached the age of 75 (this process is called an alternatively secured pension or ASP). Income under this option is restricted and is set at 70 per cent of “single life” annuity rates as defined by the government actuary.

Why don’t I get a choice as to what I do with my pension savings?

The government says that because you benefit from tax relief on your pension contributions, it restricts how you can use those funds when you retire.

How do annuities work?

In return for your pension savings, the annuity provider will work out an income, paid monthly, quarterly or annually. Your annuity income will be calculated using factors including: the value of your pension fund; the type of annuity you decide to buy (such as whether income will rise in line with inflation); your age, health and sex. Gender is an important factor as women tend to outlive men and this often means lower rates.

What are annuity rates and how are they calculated?

Annuity rates show you what annual income the provider is prepared to pay based on the size of your pension pot and how long they expect you to live. Rates will differ according to the age and health of the annuitant and other variables, such as whether you smoke or wish an income to be paid to your spouse should you die first. Annuity rates can change at any time and have been on a downward spiral for the past 15 years largely because of increased life expectancy and falling yields on government bonds (gilts). However once you have bought an annuity, your rate will be honoured until you die. Insurers mostly fund their annuity income promises by investing in long-term gilts, which are currently yielding near record lows because many pension funds are buying gilts, driving up prices (and forcing yields lower). According to the Annuity Bureau, the average annuity in 1990 (purchased with a £100,000 pension fund) was £10,000 per year compared with just over £4,000 in 2005.

It all seems a gamble?

What are the different types of annuities?

There are two types of annuities: conventional – or basic – and investment-linked. From these building blocks you can tailor your annuity to suit your needs. A conventional annuity pays a set level of income or income linked to a prescribed rate or index throughout life. Those willing to take some risk could choose an investment-linked annuity. If returns on the underlying invest-
ments are strong, your income will rise, but the converse is also true.

How do I find one that suits me?

Modern annuities can be tailored to suit your changing lifestyle and needs. Some of the choices include: “level annuities”, which pay the same income throughout your life. An “escalating annuity” will either rise by a fixed amount each year or will link increases or falls to the retail price index (RPI). But there are many different variations.

I am a heavy smoker. Will that affect my annuity?

Yes, and perversely for the better as smoking habits and/or medical conditions can reduce life expectancy, meaning you may qualify for an “enhanced” or improved annuity rate.

How will annuities change after April 6?

From April 6, a new “temporary” as opposed to a lifetime annuity will be offered which allows you to use all or part of your pension fund to buy a fixed term annuity lasting up to five years. These “Short-Term” annuities may interest those wanting to defer until rates improve. However, if you choose to buy one of these annuities, you will have to buy a lifetime annuity by the time you are 75. Another benefit from April 6 is the introduction of Annuity Lump Sum death benefit, which will ensure that if you die before 75, your money “doesn’t die with you” and can be passed on to your chosen beneficiaries.

Is it important to shop around?

Very much so. The market is competitive but research suggests that rates can differ by as much as 30 per cent between providers. The FSA has comparative tables at www.fsa.gov.uk/tables. For general information try www.pensionsadvisoryservice.org.uk