It is probably best to start with a couple of definitions of Annuities:

• 'Money paid out at regular intervals. An amount of money paid to somebody yearly or at some other regular interval'

• 'A recurring payment, which may be constant or may increase, usually made until the death of the person receiving the annuity. An annuity can also be paid to two people. In this case, the payments cease on the death of the second person'

In simple terms, an annuity is an exchange of capital for an income. You provide an insurance company with a lump sum and in return, they guarantee to pay you an income for the rest of your life, or for a fixed term. Once an annuity has been arranged, they are usually irrevocable, so you need to ensure that buying an annuity is the right decision.

There are many types of annuities available and the differencies between the best and the worst income payments can be quite large, so it is important to shop around for the best offer. Annuity quotes are time sensitive and when you get a quote, it is only usually valid for a short period.

Annuities are most associated with pension plans. The idea is that when you get to your chosen retirement age, then with the value of your pension plan, you purchase an annuity to give you an income for life.

It is possible to buy an annuity with general investment sums, rather than pension money. This is called a Purchase Life Annuity and can be useful if you have accumulated capital which you need to provide a guaranteed income.

A Purchase Life Annuity

A Purchase Life Annuity is made up of two component income parts. Firstly, your income payment is made up of a ‘return of capital’ and as such this is tax-free. The second part is ‘interest’ which is taxed at your normal rate of taxation. The split between the two component parts is dependant upon age and other actuarial factors.

There are a number of insurance companies that offer Purchase Life Annuities and it is important to get quotes from as many of these as possible to ensure that you get the best deal possible.

A Pension Annuity

Buying an annuity with the value of your pension fund is known as either a Compulsory Purchase Annuity or an Open Market Option. Under current pension legislation you must convert your pension plans into a pension annuity before the age of 75. Pension plans include: Personal Pensions, Stakeholder Pensions, Group Personal Pensions, Executive Pension Plans, Retirement Annuity Contracts, (contracts arranged prior to July 1988), Additional Voluntary Contributions (AVCs), Free-Standing Additional Voluntary Contribution (FSAVC) schemes, Section 32 Buyout Bonds and employer's pension schemes known as Money Purchase Schemes.

Under all of these schemes you can choose to either buy your annuity from the Insurance Company that you have held your pension savings with or, you can exercise an Open Market Option, which means that you are able to shop around for a more competitive annuity quote from another insurance company. Given that buying an annuity is irrevocable, it is well worth shopping around to get a competitive quote.

Types of Annuity and Terminology

Annuities come in different forms and descriptions need to be understood - Immediate; guaranteed; compulsory purchase; open market option; deferred; temporary; level; increasing or escalating.

An Immediate annuity

The purchase price is paid to the insurance company and the income starts immediately and is paid for the lifetime of the annuitant.

A Guaranteed annuity

Income is paid for the annuitant’s life, but in the event of early death within a guaranteed period, say five or 10 years, the income is paid for the balance of the guaranteed period to the beneficiaries. Very often the option to convert the remaining balance under a guarantee period into a lump sum exists.

A Compulsory Purchase Annuity

Also known as open market option annuities, these are bought with the proceeds of pension funds. A fund from an occupational scheme or buy-out (S32) policy will usually buy a compulsory purchase annuity. Sometimes the open market option exists with funds from an occupational scheme. A fund from a retirement annuity or personal pension will buy an open market option annuity – an opportunity to move the fund to a provider offering better annuity rates.

A Deferred Annuity

A single payment or regular payments are made to an insurance company, but payment of the income does not start for some months or years. This may be suitable for an investor funding for retirement or school fees.

An Annuity certain/deferred annuity certain

Often used for school fees purposes. The annuity is paid for a fixed period either immediately or after a deferred period, irrespective of the survival of the original annuitant.

A Temporary Annuity

A lump sum payment is made to the insurance company, and income starts immediately, but it is only for a limited period – say five years. Payments finish at the end of the fixed period or on earlier death.

A Level Annuity

The income is level at all times. This of course does not keep pace with inflation.

An Increasing or escalating annuity

The annuitant selects a rate of increase and the income will rise each year by the chosen percentage. For example by inflation or a fixed rate increase of say 5%.

Some life offices now offer an annuity where the performance is linked to some extent to either a unit linked or with profits fund to give exposure to equities and hopefully increase returns but there are added investment risks.

Additionally ‘flexible’ annuity contracts have become more prevalent in recent years whereby funds are retained in an investment fund and a series of temporary annuities are purchased throughout life. The risk is that the invested funds do not return sufficient to maintain the purchasing power of the earlier annuity purchases and therefore income can be at risk rather than guaranteed under a conventional annuity. Conversely higher levels of income could be achieved in the future if investment returns are good.

Annuities – Some Frequently Asked Questions

How often is my Annuity income paid?

Income can be paid annually, half yearly, quarterly or monthly either in advance or in arrears.

What happens to my Annuity when I die?

Annuities can be on one life or two. If they are on two lives the annuity will normally continue until the death of the second life.

If an annuitant dies early, some or all, of the capital is lost. Capital protected annuities return the balance of the capital on early death. Guarantee periods also provide some protection in the event of early death say for example an annuitant died in year 3 of a 10 year guarantee contract then 7 years of income will still be payable to his or her estate. Alternatively a lump sum can be offered to buy out any remaining guarantee period after death.

How is the annuity income taxed?

Payments from pension annuities are taxed as income. Non pension Purchased Life Annuities (PLA’s) have a capital and interest element – the capital element is tax free, the interest element is taxable as income.

Are Annuities good value?

The answer to this question very much depends on how much priority you give to security of income for life.

Low interest rates in recent years coupled with greater life expectancy have seriously eroded the level of income that can be purchased with the same pension funds and so it could be argued that annuities offer poor value, certainly if compared to rates available in the mid nineties. However they offer absolute income security for as long as you live so the question of whether or not they represent ‘good’ value is very much a subjective one and the answer will depend on your own individual circumstances and perceptions about risk and reward.

Are Annuities flexible?

Conventional annuities cannot be changed, transferred or surrendered for cash. This makes it essential to choose the best possible deal when the time comes. Other types of more flexible annuities exist but without the inherent guarantees of a traditional or conventional annuity.

Do I have to buy an Annuity?

Many of the financial rules governing retirement changed on 6 April 2006 – referred to as A Day. Tax rules still state that individuals must use their pension pot to buy an annuity by the time they are aged 75 although it is possible to set up an Un Secured Pension (USP) before age 75 and an Alternatively Secured Pension (ASP) from age 75. Under both the pension fund remains invested and the individual draws an income from it. There are strict rules about how much may be taken and there are punitive tax charges on death, particularly under ASP.

Do I have to accept my pension company's Annuity offer?

No. Your pension company will want you to choose its own annuity offering, but legally you don't have to. Everyone has the right to use the 'open market option' enabling you to shop around and choose the annuity that best suits your needs. A starting point could be to consult our annuity comparison tables and obtain a quote from the market incorporating our discounts to improve your return.

How will health affect annuity income?

If your health is such that you will not be expected to live as long as most other people of your age, you may qualify for enhanced payments. This type of annuity is sometimes known as 'impaired life'. You will need to speak to your annuity provider for an individual assessment but again can compare figures from the market through our comparison quotes.

What else do I need to know?

Some older pension policies have special guarantees that mean they will pay a much higher rate than the current market known as Guaranteed Annuity Rates (GARs). Such guarantees could result in a much higher income than those policies without a GAR.

A summary of Annuities

We all want to ensure that we make the right Annuity choice when we retire. Nestor Partnership can help with all aspects of your retirement planning which includes helping you with your annuity purchase. Please contact us for more details.