Are you in the dark over annuities?
June 17th, 2010
New research carried out by Sun Life Financial of Canada in April 2010 reveals that four in ten (42%) consumers do not know what an annuity is. When presented with a choice of descriptions, of which only two were correct, a quarter of people (25%) selected incorrect descriptions, with just 33% and 29% respectively identifying the two correct descriptions.
Whilst the survey of UK adults highlighted confusion of annuities across all ages, the confusion experienced by those falling into the ‘at retirement’ age group is perhaps the most worrying. 23% of over 55 year olds admitted to having no idea as to what an annuity is, with a further 23% wrongly thinking an annuity is a ‘savings pot which you accumulate throughout your working life’.
Moreover, 1% of over 55 year olds surveyed said that they thought an annuity was an ‘insurance policy that protects against unemployment throughout your working life’.
It is important for you to understand how you can take your pension in retirement as the income produced from your pension will potentially have to sustain you during your retirement and it could be required to support your spouse and/or dependants after your death.
So what exactly is an annuity?
An annuity is simply an insurance company’s promise to pay an income in return for a capital sum. This capital sum is commonly referred to as the purchase price.
You can receive your income either monthly, quarterly, half-yearly or yearly. You will probably come across a number of confusing terms, the main ones being:
• Payments can be made either ‘in advance’ or ‘in arrears’.
As an example, if an annuity was purchased on 1st June payable monthly in advance the first payment will be on 1st June. If paid monthly in arrears, the first payment will be on 1st July.
• If payable in arrears, it can be paid either ‘with or without proportion’.
With Proportion means that if you die in-between annuity payments, a proportion of the outstanding annuity payment is paid up to the date of death.
Without Proportion means that if you die in-between annuity payments, the annuity ceases on the last payment made prior to death.
The main types of annuity
Annuities will either be compulsory or voluntary.
An annuity bought using monies that have been accumulated in a pension fund is a compulsory purchase annuity (CPA). This is because the fund (after any tax-free cash has been taken) must be used to provide an income. The income arising from a CPA is taxed in full as earned income, although it would not rank as ‘relevant’ UK earnings for pension contribution purposes.
A CPA cannot be bought before age 55 (unless you have a ‘protected’ low retirement age or are forced to retire earlier due to ill health)
A purchased life annuity (PLA), on the other hand, is a voluntary annuity, which anyone can buy with spare capital. There is no ability to take a tax-free cash sum from a PLA but the advantage of a PLA is that part of each annuity payment is treated as a return of the annuitant’s own capital and the balance is treated as interest. Only the interest element is taxed.
There is no minimum age for buying a PLA although the rates available are much better at older ages.
Both a CPA (bought from pension funds) and a PLA (bought with spare capital) can be ‘whole of life’ (in which case, the annuity will be paid for the rest of the annuitant’s life, regardless of how long they live) or ‘temporary’ (paid for a set period).
The amount of income a pension annuity pays will primarily depend on:
• The size of the accumulated fund
• The amount of tax free cash taken (if any)
• The ancillary benefits chosen (such as increases in payment and any survivor pensions)
• Your age
• Whether you are male or female
• Your state of health (higher rates are available if you are in poor health or have a certain medical condition); and
• Current gilt yields (the higher the gilt yield, the higher the income will be, and vice-versa)
As one would expect, the starting income from two funds of identical size for two people the same age will usually be higher for a man than a woman. This is because, on average, the life expectancy of a man is less than it is for a woman of the same age.
The income is also higher the older you are when it is purchased. This is because, on average, an older person has fewer years to live than a younger person.
There is considerable flexibility when choosing the type of pension annuity that can be provided, but the most important options are as follows:
Level or escalating
The annuity can provide payments, which remain level throughout, or they can be arranged to increase. The rate of increase can be fixed (for example, at 3% per annum) or could be linked to increases in the retail price index.
For any given size of fund, the higher the level of increase, the lower the initial income will be. In current economic conditions, few people would opt for an increase of more than 5% per annum, although in the days of high inflation back in the 1970’s it was not uncommon for rates of 8.5% to be selected.
Many people elect to receive a level pension that does not increase, on the basis that this provides a higher initial income and best value if they were to die in the early years. However, the gamble results from the fact that the purchasing power of the income could be seriously eroded by inflation over the longer term.
It is possible for the income to continue for a minimum period, even if you die. Commonly, a 5 year term is selected and this provides certainty that some value for money will be obtained from the annuity, even if death occurs within weeks of annuity purchase, and the cost of building in a 5 year guarantee period is quite modest.
On death during a guarantee period, the outstanding balance must be paid as continuing income; it cannot be paid as a lump sum.
Payments under a guarantee period can be paid to any nominated beneficiary – they do not need to be paid to a financial ‘dependant’ such as a spouse – and the payments will be taxed as income in the hands of the recipient.
Spouse and dependants’ pensions
An annuity can also be established so that all, or part, would continue to be paid to your spouse, or some other dependant, after your death.
The amount payable to a spouse or dependant will normally be 50%, 66.66% or 100% of the amount that you were receiving at the time of your death and if an escalating annuity had been purchased, it will continue to increase in payment after your death.
It is not necessary to select the type of annuity you require until it is actually purchased – thus enabling you to defer making any decision until you reach retirement – but once selected the type of annuity cannot be changed.
The suitability of an annuity will depend on various factors such as the size of your fund, your attitude to risk, whether the fund has any valuable guaranteed annuity rates, your income tax position, whether a flexible or guaranteed income is important and whether or not there is a desire to maximise lump payments on death.
These are all issues that you should discuss with your independent financial adviser but if you are going to buy an annuity it is vital to ascertain whether you could qualify for enhanced rates and to shop around for the best rate possible.
To illustrate the importance of shopping around, the difference between an average standard and enhanced annuity rate is currently 22.7% for men and 22.6% for women (source: FSA Comparative Tables). With a £50,000 pension pot the annuity provider MGM Advantage has warned that, on average, men who choose a bottom quartile enhanced annuity could find themselves £2,297.60 worse off over the first five years of their retirement, compared to choosing a top quartile annuity, with the corresponding figure for women being £2,237.40.
The value of investments and income from them can fall as well as rise and you may not get back the full amount invested. The levels and bases of and reliefs from taxation are subject to change and their value depends on the circumstances of the individual investor.