An Annuity is a serious business!

“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.

What is an annuity?

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:

• An annuity is an investment which pays a high income for the rest of your life.
• When you buy an annuity you are turning a lump sum into a stream of future income.
• Lifetime annuities guarantee to pay an income for as long as you are alive, no matter how long you live.
• When you die, payments stop, unless you have chosen a joint life annuity or a guaranteed payment period

Annuities = income for life

The advantages of Annuities

• Annuities are the only policy which guarantees income for life. (No matter how long you live)
• They provide a high level of guaranteed income
• They are simple to understand and give security and peace of mind
• Annuities are based on the concept of "mortality cross subsidy so they insure you against out living your assets

Short history of annuities - Starting with the Romans

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.

Annuities and Pensions

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.

Investment linked annuities

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, and it is expected that more companies will launch with profit annuities as this option becomes increasingly more popular.

The market in the 21st century

In 2008 it was estimated that over £11 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 £2 billion was invested in drawdown.

Exchanging capital for income

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.

Foley v Fletcher (1858) where annuity was defined as follows:

• "An income is purchased ..the capital is gone..the principle having been converted into an annuity".

Perrin v Dickson (1929) it was said:

• " ..an annuity means that you spend your capital in buying an income."

If there were no annuities.

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.

• How much income?
• If you draw too little income you would die without having spent all your money, but you would leave money to pass on to your family.
• Yet, if you draw too much you would run out of money and have to rely on your savings or fall back on your family or the State.
• Where to invest?
• If you invest too cautiously your income will be lower, but safer
• if you invest in a more risky way, you might obtain more income if your investments perform well.

Annuities provide the answer

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

Mortality Cross Subsidy - more information about 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.

Types of annuities

Annuities come in many different shapes and sizes but they fall into basic groups - Pension Annuities and Purchased Life Annuities

Pension 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 compnany schemes and those purchased from personal pensions. This difference has now disappeared.

There are a number of types of pension annuities including:

• Standard annuities - also called non-profit annuities
• Enhanced annuities - higher income for those in poor health
• With profit - future income linked to WP bonuses
• Flexible annuities - income flexibility and investment control

Purchased Life Annuities

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.

• Lifetime PLAs - have most of the same options e.g. single or joint, guarantee periods and levels of escalation
• Temporary annuities - are only payable for a fixed term e.g. 5 or 10 years

Protected Rights from DC Schemes

Defined contribution schemes and some persoanl pensions that have contracted-out of the State earnings related pension scheme (SERPS) usually have a portion of the member’s fund known as protected rights.

At retirement this fund must purchase a protected rights annuities and these are calculated using unisex annuity rates. That is the same rates for both men and women.

Annuities purchased with a protected rights fund accrued before 6 April 1997 must provide a 50% spouse’s pension.

Annuities purchased from a protected rights fund accrued after 5 April 1997 are only required to provide a 50% spouse’s pension if the member is married when they retire. In both cases the Protected Rights annuity must be calculated using unisex annuity rates.

Following changes in the Pensions Act 2004, it is no longer mandatory to arrange a protected rights annuity with annual increases for pensions coming into payment after 6 April 2005.

Prior to these date, pre 5th April 1997 protected rights had to increase by the lesser of RPI and 3% p.a. and all benefits post 5th April 1997 had to increase by the lesser of RPI and 5% p.a. This means that protected rights annuities may be arranged with level payments.

Guaranteed Minimum Pension

Some schemes which contracted-out of SERPS before April 1997, must provide for a guaranteed minimum pension (GMP). The GMP is broadly the same pension as that which would have accrued under SERPS. In addition to the members pension, the annuity must provide a 50% spouse’s pension. The annuity purchased in respect of service after April 1988 must also escalate by at least the rate of inflation (up to a maximum of 3% per annum). From April 2005, GMP must increase by the Lesser of RPI and 2.5% p.a.

Trivial Pensions

If your total funds are valued at less than than 1% of the Standard Lifetime Allowance - £ 17,500 in 2009/2010, you will be able to be take all of your pension as cash.

25% of the fund will be tax free and the balance will be taxed at the marginal rate. More than one policy can be commuted for cash providing that the total is below 1% of the lifetime allowance.

For example an individual with a stakeholder pot of £17,500 could take £4,375 as a tax free cash sum and the balance will also be paid in cash, less basic rate tax providing another cash payment of £10,500.

It is important to remember that all pensions in payment must be taken into account when calculating the value of an pension. This means that in the example above, if the individual had a small pension in payment, this would have to be taken into payment and would take them over the 1% limit.

Ill health

Ill-health commutation will be available to anybody who's life expectancy is considered to be less than 1 year. Providing the benefits are below the lifetime allowance the lump sum will be tax free.