Flexible annuities combine many of the advantages of traditional annuites such as an income for life, with some of the advantages of drawdown such as flexibilty and the option to invest in the stockmarket. Most flexible annuities have the following advantages :
Collectively these annuities are also known as‘Investment Linked Annuities’ or ‘Asset Backed Annuities’. The most well known annuity in this group is the ‘With-Profit Annuity’ which as its name suggests is invested in a with-profits fund. Included in this group is the ‘Fixed Term Annuity’.
When a traditional (non-profit) annuity is set up, the options selected cannot be changed a later date even if the circumstances change. For instance if it is a joint life annuity and the partner dies first the annuity cannot be re-priced to reflect the higher rates for a single life annuity. Or if your circumstances changed and you wished to alter the level of income, you cannot change your income.
However a Flexible annuity gives you income flexibility, investment control and choice of death benefits.
There are three types of flexible annuity
Potential for income growth
Future annuity payments may be lower than expected if investment returns are lower than projected
Increases in future life expectancy can be passed on to the policyholder through changes to survivor bonuses
Income flexibility
If too much income is taken in the early years it may result in lower income in the future
Investment control
Investment returns and survivor bonuses may not be sufficiently high to compensate for mortality drag
Joint life options
Before explaining how these annuities work, it is helpful to consider why you should consider investing some of your pension pot in these policies. Most people need a pension income which has the potential to increase over time in order to meet a rising cost of living and life expectancy but find inflation linked annuities too expensive. The starting income from an inflation linked annuity is some 40% lower than a level annuity and it takes over 14 years to overtake the level annuity and over 25 years for the total payouts to be the same. Many people retiring now simply don’t know how much income they will need in future years or when they will need it. Nor can they be confident that their personal circumstances will not change.
Therefore it is helpful to have an annuity offering flexibility. Providing you understand and accept the risks, investment linked annuities allow you to benefit from future growth if future returns are higher than anticipated and to have flexibility over the amount of income you receive. The risk is that in certain circumstances the level of income could fall.
Whilst there are obvious advantages to guaranteed annuity payments, the disadvantage is that the spending power of a fixed income will fall over time as inflation takes its toll. For instance, inflation at 3.5% per annum will halve the spending power of a fixed annuity after 20 years. So investors buying a level annuity may think they are not taking any risk but they are exposed to the real risk that their income will buy a lot less in the future.
This results in what we call the ’Risk Paradox’. Put simply, many retired investors might have to take some risk with their annuity income in order to end up in a less risky position. Investing in investment linked annuities means taking some risk but if by doing so the future level of income increases in value to help offset the effects of inflation, this might be less a less risky strategy in the future.