Annuities
Pensions
An annuity provides an income, either for life or for a specified period, in exchange for a lump sum investment. Once the annuity has been bought, you cannot get your lump sum back and you are tied into the income agreed.
The level of income that you will receive from an annuity depends upon:
- How much you invest
- Your age
- Your health
- Sex
- The prevailing annuity rates at the time you invest
Generally speaking, the older you are the more pension annuity (income) you will receive. Once you've bought an annuity, the income you will receive will be stipulated for either the rest of your life or the term of the annuity. The joker in the pack, however, is the fact that annuity income rates vary so much over time and from provider to provider, just like bank and building society rates.
How they work...
Annuities are supplied by life offices. Like any organisation, they
exist to make a profit and will endeavour to do so out of you. The
income you will receive from an annuity is dependent upon many things,
such as the investment conditions at the time you take it out.
Most, but not all, annuities offer some form of guaranteed income. To support this guarantee, the life offices invest in fixed interest investments, usually long term government gilts. The rate of return of these gilts varies over time and so therefore do annuity rates.
Another big influence is your age. The insurance company will adjust the payments it offers you depending upon how long it expects you to live. It follows that if you buy an annuity at 75 you will secure a much better rate than you would at 55. Also women statistically live about seven years longer than men, so women tend to attract lower annuity rates than men. However certain annuities, like the ones funded by 'appropriate personal pensions' are calculated on a unisex basis, with both men and women receiving the same rates.
Health can also affect an annuity's rates. Someone suffering from a fatal disease will often secure higher rates since the insurance company will expect to pay out for a shorter time.
The major drawback of traditional annuities is that the terms are set and cannot be changed once you've handed over your lump sum. This is obviously a disadvantage if you happen to be retiring when rates are low. To counter this, there are now methods of phasing your retirement, to allow you greater control over when you commit to an annuity.
There are two main types of annuity.
Compulsory purchase annuities (CPAs) must, and can only, be bought with the bulk of the proceeds from a money purchase pension, such as a personal pension plan or the proceeds of a money purchase employer's scheme.
Purchased life annuities (PLAs), on the other hand, can be bought by anyone with spare capital.
The difference between the two is that with CPAs, the full income is taxable whereas with PLAs, only the interest element is taxed. The element of income that represents a return of capital is not taxed.
Hence, a tax free lump sum from a pension will for some people produce more income via a PLA than if it had been left with the rest of the pension fund and purchased a CPA.