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Guide To Annuities

What are Annuities?

In its simplest form, in exchange for a lump sum payment, an insurance company will pay you an income (an annuity) for a specified period.

How do Annuities work?

There are a number of different types of annuities, but they all work essentially in the same way. In exchange for a capital sum payable by you to an insurance company, you will receive a regular income, the level of which is determined predominantly by your age at outset, whether you require a level income or one that increases year on year, how long the income is payable for and current gilt returns (a type of government debt) which is broadly linked to interest rates.

In addition to this, depending upon the type of annuity chosen, whether you are male or female may have a bearing on the level of income payable to you.

Annuities can be payable for your lifetime (as in the case of pension annuities) or for a specified period of time (say, five or ten years) as in the case of non-pension and those annuities used for investment purposes. There is no cash-in value and on your death, generally any annuity will cease.

Am I likely to require an annuity?

The most likely time that you will require an annuity is when you come to take your pension income. If you wish to have certainty of income during your retirement without taking any risk with your pension fund, the most appropriate course of action may be to use your pension fund to purchase an annuity.

However, there are many other instances when an annuity provides you with the most appropriate solution to your needs, for example, you have a capital sum and wish to provide a fixed income for a specific period.

You can tailor your annuity to best suit your needs in retirement and can choose the following options:-

If you are married, have a civil partner or dependant, you can include a "spouse's" or "dependant's" pension which becomes payable on your death and can be at the same level as your pension, or can reduce by one-third or one-half. If your spouse or civil partner pre-deceases you, no additional pension is payable.
You can choose to have your pension annuity payable for a minimum period of time, irrespective of how long you live. This "guaranteed period" aims to provide some protection so that should you die in the early years, you (or your estate) have received some benefit from your pension fund. It is quite common for investors to incorporate a guaranteed period of five (or ten) years meaning that your annuity will be payable for a minimum period of five (or ten) years or your lifetime, if longer.
In its most basic form, an annuity will provide you with a level income for your lifetime. If you wish to protect against the effects of inflation, then you are able to incorporate an element of indexation so that the annuity income will increase year on year. You can choose to have fixed increases, for example, 5% per annum or for any increases to match the prevailing RPI.

It is important to be aware that the more "bells and whistles" you incorporate into your annuity, the lower that you initial income will be. So that, for example, if your annuity will pay a 50% spouse's pension on your death, is guaranteed for ten years and will increase at RPI, you can expect a significantly lower initial annuity income than if you had chosen a single life, level pension with no guarantee. Even allowing for increasing annuity payments, it could be more than 15 years before your income reaches the same amount as the non-increasing annuity.

However, the important thing is that you have all the options to hand so that you can make an informed decision which is most appropriate to your circumstances at that time.

Will I be taxed on an annuity?

This depends on what type of annuity it is. An annuity which is related to a pension scheme will be taxed as earned income and will be added to your other income when calculating your liability to income tax.

However, an annuity which is not pension related is likely to be taxed more efficiently as part of the annuity payments will deemed to be repayments of capital and as such, tax free. The remainder will be taxed as interest at 20%. Non-taxpayers will be able to reclaim this and higher rate taxpayers will be required to pay an additional 20% income tax to bring their total liability to 40% on the interest portion of the annuity payment.

As there is no cash in value, annuities are not subject to Inheritance Tax and can, therefore, make a useful planning tool in this respect. In addition, as there is no "capital gain" on an annuity, there will be no capital gains tax to suffer.

Anything else that I need to know?

Impaired life annuities are becoming ever more popular. These annuities recognise that people who meet certain conditions, for example, smokers, the overweight, those with health issues, etc, may have decreased life expectancy and as such, more favourable rates may be obtained, compared to those deemed to represent "standard" lives. Indeed, some companies now provide preferential rates to those who live in areas of the country where life expectancy has proved to be reduced. It is important that if you feel you may fall into one of these categories, you inform your adviser to ensure that the best rates for your circumstances are obtained, thereby maximising your income.