The key to your future

For most people, buying an annuity is something they will only do once in their life. Therefore you need to be aware of the options available. Below you will find a brief guide to annuities, and the options available.

Types of annuity

Conventional Annuity - this is the most common form of annuity, it is  a guaranteed income for lifetime 

Impaired Life/Smoker Annuities - if you smoke or have had medical problems then you may qualify for an enhanced annuity. The reason for this is your life expectancy is statistically shorter

Investment Linked Annuities/With Profits Annuities - these offer many of the options of a conventional annuity, but with the addition of an investment linking, which could mean that your income increases in the future.

Short-Term Annuities - Legislation also permits the purchase of short term annuities to enable the purchase of a temporary income, while leaving the remaining funds invested.  These annuities have a maximum term of five years or up to age 75 if one is purchased after age 70. A lifetime annuity will have to be purchased by age 75, or the funds can be transferred to an alternatively secured pension.

Options

Single Life- this is the term given when you purchase an annuity for one person. It means that is payable only for the lifetime of the annuitant (the person buying the annuity), unless there is a guarantee period added to the contract (see below).

Joint Life - when you take out your annuity, you may want it to continue in the event of your death for your spouse or partner, and this is what is called a joint life annuity.  A joint life annuity does not have to continue at the same level as the original starting level, but it could be 100% of the initial annuity, or two thirds or half, or whatever percentage you require. The greater the spouse's pension then the lower the initial level of income.

Guarantee Period - most people take out an annuity with either a five or ten year gurarantee. The guarantee means that the income will be paid for  at least the length of the guarantee period. e.g.  If you took out an annuity with a five year guarantee but died after two years, it would pay out for a further three years.

Value Protected Annuities - rather than opting for a guarantee period it is possible to opt for value protection. A value protected annuity would return the original purchase price of the annuity, less the total gross payments made, if the annuitant were to die before age 75. This payment would be subject to a tax charge of 35%. For joint life annuities the value protection can be arranged to pay out on the death of the annuitant before the spouse (first life), or on the death of both the annuitant and the spouse. They are also known as "capital protected annuities".

Level Basis - means taking out an annuity which will not increase each year, but will pay a fixed amount for the life time of the contract. The downside is that its value will be reduced in real terms over time.

Inflation Protection/Indexation - this option ensures that your annuity has some protection against inflation. You can opt for it to increase by a fixed amount each year, or by the rate of inflation. The disadvantage is that the starting amount of income is much lower than a level annuity. In many cases it can take years for the level of income from an increasing annuity to catch up to a level (non-increasing) annuity.

Triviality

Triviality - If you're over 60, and you have pensions worth £15,000 or less, or its equivalent if you have pensions in payment or other deferred pensions, then it is possible to take the fund as a lump sum, and not buy an annuity at all. 25% of the fund is tax free, and the remaining part of the fund is paid out as lump sum, but this this is subject to income tax.

Tax-Free Cash

Tax-free cash - Most pensions now offer tax free cash. But if they do, then you should seriously consider taking this money even if your main requirement is for income, since you may be able to invest the money in a more tax efficient way, as all the income from an annuity is taxable.

Amount of tax-free cash - Most personal pensions offer 25% of the fund as a tax free lump sum, but some other contracts can actually offer more or less tax free cash than 25% of the fund. By transferring a plan which has less than 25% tax free cash available it can be possible to increase the tax free cash to 25%.  

Alternatives to annuities

Income Drawdown - this is not a type of annuity at all. It is an alternative method of taking an income, and taking the tax-free lump sum from your pension. There are also some advantages over the benefits in the event of death, as the remaining fund can be paid out (less tax). The level of income taken is based on rates set by the Government Actuaries Department (GAD), and the maximum is approximately the same as a level, single life annuity. There is no requirement to take any income.

This contract can work well if the fund grows, and the level of withdrawals do not exceed the fund growth. However, there are risks. Not only is there the risk that the fund could fall in value, but also annuity rates could fall.  Additionally, there is the loss of a cross-subsidy, since when you purchase your annuity, some people will not get their money back because they will die relatively soon, whereas those who live longer will get more than their initial investment in regular payments, and they will have been subsidised by those who died earlier. This is the cross-subsidy, sometimes known as the mortality drag.

New rules in April 2006, have brought added flexibility to this type of contract, removing the previous requirement to take an income, and making a similar type of contract available to those over 75. Click here go read more on income drawdown.

Phased-Retirement

Phased-Retirement Using Annuity Purchase - if you do  not want the tax-free lump sum from your pension, then this could be a tax efficient way of taking an income from your pension. You may not be aware that you do not have to take all your tax-cash in one go.

Effectively you take a portion of the tax free cash to use as income, and the remaining part you use to purchase an annuity. e.g Assuming you had a fund of £100,000 and a wanted to receive an income of £3500. You could take a tax-free lump sum of £3000, which would mean that you would need to use (vest) £12,000 of your existing funds. The remaining £9000 would then purchase an annuity. Assuming that the £9,000 was able to purchase an income of £500 per year, then you would receive £3500 - £3000 tax free and £500 taxable.

The process is repeated each year, and is flexible. However, as each year passes more of the income is made up of annuity.

This type of contract also has some advantages. It means that you can take an income from your fund without having to purchase an annuity with the entire fund, and enables you to keep your monies invested. It also means that not all the money you receive each year is liable to tax. In the event of your death then the non vested portion could be paid out to your estate free of tax.

The downside to this type of contract is the lack of access to the tax-free cash. There is also the risk that annuity rates could fall.

Phased Retirement Using Income Drawdown - The principle for this is the same as above, except the fund after taking any tax-free cash goes into an income drawdown contract to provide the taxable income. Click here to find out more about income drawdown.