“An annuity is a very serious business; it comes over and over every year, and there is no getting rid of it”, wrote Jane Austen in Sense and Sensibility in 1811.
Annuities are still a serious business today because they are the only financial product that can provide a safe and secure lifetime income for retired investors.
An Annuity is an investment that guarantees to pay a secure income for the rest of your life, no matter how long you live.
In the UK there are basically two types of annuities; pension annuities (compulsory purchase) and purchased life annuities (voluntary purchase). All annuities share the following characteristics:
Annuities are one of the oldest financial contracts and their origins can be traced back to Roman times, when policies known as annua promised to pay income for a fixed term, or possibly for life.
Annuities were available in the Middle Ages, the most famous of which were known as tontines. These policies paid an income for life, and every year the payouts for those who died were spread amongst the survivors. The last surviving policyholder received the remaining capital. Thus they combined the concept of insurance with an element of gambling.
The last surviving policyholder received the remaining capital. Thus they combined the concept of insurance with an element of gambling. During the 1700's several governments including England and Holland sold annuities in lieu of government bonds. Today they play a very important part in retirement planning, and last year the annuity market was over £6 billion
During the 1700's several governments including England and Holland sold annuities in lieu of governments bonds. In the 19th century annuities were used to provide income for elderly relatives or employees.
However it was not until the introduction of self employed pensions nearly 30 years ago that annuities started to play an important role in the UK pensions market. The early self employed pension plans (s226 contracts) were in fact deferred annuity policies i.e. investors saved up for an income, but this income was secured by way of an annuity. Most contracts contained an open market option, which gave the investors the right to buy a better annuity from another company.
Personal Pensions were introduced in 1988 and required that an annuity had to be purchased to secure retirement income, and all these contracts contain an open market option. Pension drawdown was introduced in 1995 and this allowed the annuity purchase to be deferred until age 75, but in the meantime an income could be drawn from the pension fund.
Annuities that invest in the stockmarket, commonly known as Investment Linked Annuities, have been available for some time. Commercial Union, and Provident Mutual were amongst the first to offer these, followed by Equitable Life, Prudential and Scottish Widows. In August 1999, Norwich Union and Sun Life introduced with profits annuities followed by Standard Life and Liverpool Victoria. Following the stock market crash which started in 2000, the uptake of with-profuits annuities fell and several companies including Standard Life pulled out of the market.
With-profits annuities suffered a bad press following the troubles at Equitable Life when investors saw their income fall significantly as bonuses were reduced or removed
In 2007 Hartford Life introduced a variable annuity into the UK market. This was a pension plan with a guaranteed withdrawal (drawdown option) option. Other companies such as Lincoln (now Sun Life Financial) and Met Life also launched similar so called 'third way' products
More product development followed with Living Time launching a fixed term annuity.
In 2009, Prudentail revamped its with-profits annuity and launched Income Choice which is a more transparent version of the with-profits policy
In 2010 MGM launched a new investment linked annuity, the Flexible Investment Annuity (FIA)
In 2010 it was estimated that over £12 billion of pension annuities were purchased, of which about 83% were non profit and RPI annuities, 12% were enhanced annuities and the remaining 5% being investment linked annuities. The annuity market is growing at about 10% per annum, and the share of with enhanced annuities is increasing is growing rapidly. Over £4 billion was invested in drawdown.
There is remarkably little legislation around the definition of an annuity, although there are two cases that are still used today to define an annuity.
In order to understand how annuities work, consider what would happen if there were no annuities. If you wanted an income from your pension fund when your retire, you would have to make regular withdrawals. However this would create two problems.
Annuities efficiently convert capital into income by providing a high level of guaranteed income for life with no risk. This is achieved by investing in fixed interest investments and applying a mortality cross subsidy
When someone buys an annuity, the insurance company works out their normal life expectancy and calculate the level of their annuity payments. However not everyone lives to their normal life expectancy and the insurance comapny makes a profit for them. However the insurance company uses this profit to pay the pensions of those people who will live past their normal life expectancy.
This means that those who die before their normal life expectancy subsidises those who live longer than expected.
Annuities come in many different shapes and sizes but they fall into basic groups - Pension Annuities and Purchased Life Annuities
Also called "Open Market Option Annuities" or "Compulsory Purchase Annuities"
All money purchase pension schemes provide the option to purchase a lifetime annuity at retirement. Before April 2006 there was a big difference between annuities purchased form company schemes and those purchased from personal pensions. This difference has now disappeared.
There are a number of types of pension annuities including:
A Purchased Life Annuity (PLA) is very similar to a pension annuity, except that you invest your own money. Part of each payment is deemed to be repayment of your original capital and so that part of the payment is tax free. Therefore you only pay tax on a small amount of each payment.