What is an annuity?

What is an annuity?

An annuity is a product normally purchased from an insurance company which, in exchange for a lump sum, pays out income on a regular basis from retirement for the lifetime of the member.

The amount of income and the frequency of payment depends on a variety of factors, some of which the member can choose.It is important for a member to understand:

  • The type of annuity that would be best for them
  • How it can be tailored to suit their circumstances
  • The impact of the benefits they choose

Once purchased, the type of annuity cannot currently be changed so it is essential to make the right choices at the outset.

There are various types of annuity:

CONVENTIONAL ANNUITY

  • The most common type, also known as lifetime annuities or compulsory purchase annuities.
  • As soon as the pension funds are paid to the insurance company, an income starts to be paid to the member.
  • They provide a guaranteed income stream for the remainder of the annuitant’s life. The annuitant could be the member’s spouse/dependant if the annuity was purchased on a joint life basis.

INVESTMENT ANNUITY

A type of lifetime annuity where part of the income is guaranteed and part is linked to investment performance.

  • The member selects the guaranteed level of income required and additional income paid based on the investment returns received.
  • Income would be higher if investments are performing well but only the minimum guaranteed amount would be paid if investments are not performing.

FIXED TERM ANNUITY

  • Also known as temporary annuities, they pay an income for a fixed term or until the member dies, if earlier.
  • This type of annuity is likely to offer a higher amount of income than a conventional annuity due to the shorter payment period.
  • HMRC consider short-term annuities (less than five years) to be a form of drawdown.

DEFERRED ANNUITY

  • A type of annuity that allows a person to defer receipt of income payments until a future date.
  • There are various types that can be set up with a lump sum, or more often, the annuitant makes regular payments into it. During this accumulation phase the payments gather interest.
  • The distribution phase is when the provider begins to pay out the annuity which is paid for life.
  • There is no access to any tax free cash.

PUCHASED LIFE ANNUITY

  • This is purchased with a lump sum and is generally for people who want to maximise their income on retirement and receive a guaranteed income for life.
  • Purchased Life Annuity rates generally provide a lower level of income than Compulsory Purchase Annuity rates but the tax treatment is more favourable consequently, a higher net income is generally payable.
  • Payments received consist of two parts – capital and income. The amount of capital depends on various things such as age and gender and is free of tax; the interest element is taxable.
  • Flexi-access Drawdown

An alternative to buying a lifetime annuity.

  • The member leaves their pension pot invested and takes an income directly from it.
  • The member controls the amount of income that is withdrawn.

Open Market Option (OMO)

A defined contribution pension scheme will allow a member to "shop around” and buy their annuity from the insurance market rather than taking the pension offered by the scheme.

Why would a member do this?

  • The default rates offered by their own pension scheme may not be competitive.
  • The member may qualify for an Impaired Life Annuity which pays a higher income if there is a health problem.

THE PURCHASE PRICE OF AN ANNUITY

Where can the member get the money from to purchase an annuity?

The cost of purchasing an annuity is known as the purchase price.

For a defined contribution scheme member, where units are purchased, it is calculated as:the number of units in the pension fund x the unit price at retirement.

For example:

  •  41255.604 units x £1.56 = £64,358.74

Which is the amount available to purchase an annuity.

  • Each time the member paid contributions into the pension scheme an amount of units was purchased which keeps accumulating until retirement.
  • The unit price is provided by the investment fund manager. It will fluctuate daily depending on how well the fund is performing so the actual purchase price is not known until the units are disinvested.

A member has the option of taking part of their pension benefits as a tax free cash sum (usually up to 25%) therefore, the amount available to purchase an annuity would be reduced accordingly.

For a defined benefit scheme member the benefits are calculated in accordance with the scheme rules and the insurance company then calculates the cost of providing those benefits.

A member usually has the option of surrendering part of their pension benefits in exchange for a tax free cash sum. The insurance company will calculate the amount required to provide the residual pension and any dependant’s pension payable.

ADDITIONAL VOLUNTARY CONTRIBUTIONS (AVCs)

The member may have paid AVCs whilst a member of an Occupational Pension Scheme to increase their pension in retirement.

The funds from these AVCs can be used to purchase an annuity.

OCCUPATIONAL PENSION SCHEMES

These are employer sponsored schemes and the most common type where an annuity has to be purchased on retirement is a defined contribution/money purchase scheme. However, there are some defined benefit schemes who extinguish future liability by purchasing a member’s pension (and any dependant’s pension payable) with an insurance company when they retire.

Other arrangements

A couple of other pension arrangements the member may have are:

  • Self-Invested Personal Pension Schemes (SIPPS)
  • Automatic Enrolment Pension Scheme

PERSONAL PENSION PLAN

The member may have an individual personal pension plan if they have not always been in a scheme arranged by an employer or if they have contributed to a personal pension plan rather than making AVCs. An employee may also have a personal pension plan through membership of an employer’s workplace group personal pension arrangement.

COMBINING PENSION FUNDS

A member may have worked in different companies and have more than one pension fund when they come to retire. It may be possible to combine them to purchase one annuity.

ADVANTAGES

  • Retirement income comes from one source so is easier to manage.
  • The amount of income is maximised due to a higher purchase price.
  • Only one set of initial charges when purchasing the annuity.

DISADVANTAGES

  • The charges to surrender the different pension arrangements may be high.
  • The scheme rules may not allow it.
  • The pension scheme may provide a guaranteed annuity rate (GAR) that provides a higher level of income through the scheme than the open market can offer.