What is an annuity?

In this blog I will discuss What is an annuity?

Pensions have 2 different phases:

  • the growth phase – while you are working, you pay into your pension and want to grow the fund
  • the income phase – where you use your pensions to generate an income usually in retirement

An annuity falls into the latter.

What is an annuity?

An annuity is a product which is used to pay a guaranteed income, usually in retirement.  Say for example you had been paying into a personal pension and when you came to retire you had a fund value of £133,333.33. You would be entitled to take a tax free amount of 25% of the fund value. If this was taken as a lump sum, it would leave £100,000 which could be used to purchase an annuity; an income for the rest of your life. So, you would hand over your £100,000 and the annuity provider would pay a guaranteed income for the rest of your life.

You do not have to use all of your pensions to buy an annuity. You could use some of your pensions to secure an income via an annuity and utilise drawdown with the balance for example.

The amount you receive will depend upon a number of factors including the purchase amount, your age, state of health, whether you want to build in any guarantees, a spouse’s pension or escalation.  Prevailing annuity rates are linked to interest rates.

What is an annuity?

Where can you buy an annuity?

Some pension providers who facilitate the “growth” phase of pensions also offer annuities. The option to purchase an annuity with your existing provider will be outlined in your retirement options pack. However, they may not always be the most competitive and therefore it is a good idea to explore purchasing an annuity via the open market option (OMO).  This just means going to the market to see who will provide you the most income in return for your purchase amount i.e. shopping around.  I would suggest you speak to a financial adviser however, if you would like to find out how much you may get for your money, the Money Advice Service has a very good comparison tool: https://www.moneyadviceservice.org.uk/en/tools/annuities

At the time of writing, a single life annuity for a 65 year old male (in good health) with £100,000 purchase amount would provide £5,210 per annum for the rest of his life.  So if this chap, let’s call him Bob lives for over 20 years, he will have received his £100,000 back – the longer he lives beyond this point, the more he receives and Bob is the winner.  However, if he dies within the first 20 years, he will not have received all his money back.

You may be wondering what might happen if you hand over your £100,000 to said provider and die the next day. If so, read on…..

Guarantees

When purchasing an annuity, you can buy a guarantee.  This will guarantee that your pension will be paid for the period of the guarantee. For example, if Bob bought a guarantee of 15 years on his annuity, if he dies in year one, the annuity will continue to be paid for a further 14 years.  A guarantee can be purchase for 5, 10, 15, 20, 25 or 30 years.

The cost of purchasing a guarantee is not a huge amount – for Bob an annuity with a 15 years guarantee would provide an income of £4,955 per annum.  This is £255 less each year for the peace of mind that the annuity will be paid for a minimum of 15 years.  This would pay out a minimum of £74,325.

Joint life

You can also add a dependent or spouse to an annuity. This means that if/when you (or Bob in our example above) dies the annuity will continue to be paid to the joint life annuitant for the rest of their life.  The amount they receive will be either 50%, 66% or 100% of the annuitant’s income. This will depend upon the amount selected at outset.  This can cost significantly more than a guarantee period especially where a spouse is considerably younger than the annuitant.

For example, if Bob was married and bought a joint life annuity of 50% of his pension for his wife who was 5 years younger than him, with no guarantee, this would provide an income of £4,675 per annum.

Escalation

Inflation can erode the buying power of money over the years, therefore, you can build escalation into income from an annuity.  This is the most costly addition to an annuity.  The escalation can be 3%, 5% or linked to inflation (RPI).

If Bob purchased an annuity with 3% escalation, his starting annual income would be £3,486. It would take 14 years for this income to exceed the initial income Bob would receive from a pension with no guarantee or joint annuity (£5,210).

Enhanced annuity

If you smoke or have a medical condition, you could be entitled to an enhanced or impaired life annuity.  It is therefore a good idea to disclose all details to push your income as high as possible.

For example, if we take our first scenario with no guarantees, a single life annuity with no escalation, if Bob now smokes (and has since the age of 20), he could receive an annuity of £5,615 – that’s an extra £405 each year.

Guarantees, joint lives and escalations as well as medical conditions can be added to an annuity in any combination.

Payment frequency

You can chose to have your annuity paid monthly, quarterly, half yearly or annually.  In addition you can also decide whether you want this payable in advance or in arrears.  This can have a slight bearing on the annuity payment amount if, for example you had it paid annually in arrears rather than in advance.  This would mean you would have to wait a year for the first payment amount.

Fixed term annuities

Fixed term annuities are like lifetime annuities (outlined above) but they provide income for a fixed number of years – between 3 and 20 years with a maturity amount at the end of the term. When buying a fixed term annuity, you would have to consider the term and whether you want a fixed or interest linked income as well as all the other factors outlined above.

Conclusion

I started writing this thinking that annuities are really simple and it would take me about half an hour to write. It has taken me well over 2 hours writing this to explain What is an annuity?  In essence, an annuity is an income for the rest of your life or for a fixed term.  However, there are a number of factors that need to be considered when thinking about buying an annuity.  Unless it is a fixed term annuity, the decision is a one off and the annuity will pay an income for the rest of your life. There is currently no way “selling out” of an annuity.

If you are approaching retirement and would like to consider your options, contact me for a no obligation complimentary initial meeting.

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