Annuities

What is an annuity?

An annuity is a special investment sold by insurance companies. It is a way of converting a lump sum, usually the pension fund you have built up during your working years, into an income during your retirement which is guaranteed until your death. The type of annuity you choose at the outset, and the benefits it provides, will affect the amount of income you get, both initially and over the years. Because you can't normally change your annuity once you've bought it, it is vital to check all the options available so you buy the one that best suits your needs.

Conventional annuities are simple, offer peace of mind as the income is fixed and guaranteed until death. However, they do lack flexibility. Once an annuity is purchased you are locked in for life, as it cannot be changed. Annuities are currently offering poor value and current rates are low due to low interest rates and increased life expectancy. They also offer limited death benefits, as there is no return of capital to pass on to your spouse, family or dependents.

What different types of annuities are available? There are different annuities to suit different needs, the most common of which are

Level
Increasing
Investment-Linked - (With Profit & Unit Linked); and
Impaired Life/Enhanced annuities Level

Level Annuity

A level annuity (sometimes called a 'conventional' annuity) pays the same income year after year for the rest of your life. The main drawback of a level annuity is that what you can buy with the income at outset falls as prices rise, i.e., it is affected by inflation. For example, suppose at the start of retirement your weekly grocery bill is £50, if inflation averages 3% a year for 15 years, their cost would rise to almost £78 a week. If you could still afford only £50, you would be able to buy fewer groceries.
Increasing

Increasing Annuity

An increasing annuity provides an income with some protection against inflation. There are two main choices:

escalating annuities where your income is guaranteed to increase at a fixed rate each year, commonly by 3% or 5%.
RPI-linked annuities where your income adjusts each year to reflect changes in the Retail Prices Index (RPI) - the main measure of inflation used by the government.

The main drawback with an increasing annuity, is that the starting income is a lot lower than you would get from a level annuity. For example, for a man age 65, the starting income from a 5% escalating annuity might be two-thirds or less of the amount from a level annuity. It could take more than 10 years for the escalating income to catch up, and nearly 20 years before the total you'd received from the escalating annuity exceeded the total paid by the level annuity.

Investment-linked annuities

This type of annuity offers the chance of a higher income than you can get from level or increasing annuities (often called 'conventional annuities') linked to fixed-interest assets such as gilts and bonds. But you need to be comfortable with linking your income in retirement to the ups and downs of the stockmarket.

Investment-linked annuities are more risky than conventional annuities because:

your income is likely to change each year, so could go down as well as up;
the size of any increase is unpredictable.

Investment annuities can either be 'with-profits' or 'unit-linked'.

Impaired-life/Enhanced annuities

Some companies offer annuities which pay you a higher-than-normal income if you have a health problem that threatens to reduce your lifespan - these are called 'impaired-life annuities'. Relevant health problems might include, for example, cancer, chronic asthma, diabetes, heart attack, high blood pressure, kidney failure, multiple sclerosis or stroke. It is quite possible that someone qualifying for an impaired-life annuity could see there income improve by as much as 30%*.
You might even qualify for an 'enhanced annuity' if you are overweight or smoke regularly. Some companies even offer better rates to people who have followed certain occupations, and to individuals living in certain parts of the country!

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