This page describes the traditional (original) with-profits annuity policies as offered by Aviva, L&G and LV=. Prudential sold a tradional with-profits annuity until 2009 when it launched Income Choice Annuity
As the name suggests, these annuities are invested in a with profits fund. This means that annuitants will share in the future investment gains or losses of the fund and therefore their annuity income will increase or decrease in future years depending on bonuses. This is in contrast to standard non-profit annuities where the income is guaranteed but there is no investment growth.
Conventional annuities, correctly called non-profit annuities, provide guaranteed income for life, but they are based on bond yields and unless an expensive escalation option, future income will be static. However with many individuals facing increased expenditure and longer life expectancy, many are questioning whether non-profit annuities are the right answer for them and are asking whether it is advantageous to consider with-profits annuity
A with-profits annuity breaks the link between annuities and low bond yields and provides the opportunity for longer-term income growth but with a degree of risk. With-profits annuities have many of the characteristics of non-profit annuities but the main difference is that the future level of income will vary depending on the value of with profit bonus.
The basic level of income is calculated in similar way to non-profit annuities, by taking into account the purchase price, the expected life expectancy of the annuitant and the options chosen but no account is taken of future investment returns.
The income calculated in this way will be lower than a level non-profit annuity but it is possible to increase the starting income by taking into account some of the likely investment growth during the coming year by selecting an anticipated bonus (ABR).
The ABR can currently be anywhere between 0% and 5% and effectively allows a policyholder to borrow against future income payments. At the end of the year the anticipated bonus is subtracted from the annuity before adding the actual bonuses declared in that year. If the anticipated bonus is lower than the declared bonus, the annuity payments increase and vice versa.
Just to make things more complicated there are two types of bonus. A regular bonus and a top-up bonus. A regular bonus is added to the pension each year and the new pension amount is carried forward each year. If a top up bonus is added it is only used to increase the annuity in that year, and it is not carried forward.
The anticipated bonus is very important because it determines the level of starting income, and it affects the rate at which the annuity will rise or fall in the future.
The logic for with-profits annuities is that an investor aged 60 may have over 25 years to live and if an annuity is a long term investment, it should be backed by a suitable long term investment. For investors who believe that in the longer term a with-profits fund will out perform fixed interest and beat inflation, with-profits annuities provide an important alternative to non-profit annuities.
Standard (non-profit) annuities provide guaranteed income but with no risk. This is true in nominal terms but a fixed income provides no protection against inflation and so its real value will fall over time. The only risk free annuity is an inflation-linked annuity, but the relatively low starting income makes them unattractive to many investors.
Although with-profit annuities in no way guarantee to increase more than inflation, they do offer the potential for the best of the both worlds. That is a relatively higher income compared to a non-profit annuity and the prospect of an income that will increase in value over the long term.
They are more risky than non-profits annuities and it is important the higher risks are explained to annuitants.
With profit annuities have the normal annuity options, e.g. single or joint life and choice of guaranteed periods and payment frequencies. However instead of being invested in fixed interest, they are invested in a combination of fixed interest, property and equities. With profit annuities are more risky than standard annuity because the level of income may fall in the future.
One of the most important features of a with-profits annuity is the anticipated bonus rate (ABR). This enables you to estimate how much you think your With-Profits Annuity income will grow each year, and it determines your starting income.
For example if you select a 4% ABR, the starting income will be similar to a standard level annuity. This makes sense because standard annuities are priced in relation to yields on fixed interest and this is currently about 4%. The ABR is effectively the yield on which the WPA is priced. Whereas the yield on the standard annuity is fixed for the term of the annuity, the annual bonuses on WPAs change every year.
This means that if year 2 the declared WPA bonus is higher than the ABR the WPA income will increase, whereas if the bonus is lower the WPA income will fall.
If the year 2 declared bonus is 5% the Year 2 income increases to
If you select a low ABR, say 0%, then your starting income would be lower but all bonuses awarded would result in an increase to income.
To key to understanding how with profit annuities work it is important to appreciate the difference between an "anticipated bonus" and the "declared bonus".
The ABR determines the starting income and is used when calculating how much the income goes up or down at the anniversary of the policy
The higher the ABR, the higher the starting income. An ABR 0f 4% will currently provide a starting income similar to a level annuity.
However a high ABR reduces the scope for future income growth as it is deducted from the annuity each year before applying the new bonuses
Declared bonuses are the actual bonuses awarded to with profit policies each year.
There are two types of bonuses. Regular or reversionary bonuses and Top up bonuses or terminal bonuses.
A regular bonus is added to the pension each year and the new pension amount is carried forward each year. If a top up bonus is declared, it is applied in that year only.