What is an annuity - an annuity is a product which pays a regular amount to you – monthly, quarterly, or annually – in return for an initial investment. It is sometimes referred to as a ‘lifetime annuity’.
Annuities pay only the person who takes out the annuity; they cannot pay a partner or spouse.
You can choose to have the annuity pay out to your partner or spouse in the event of your death, or create a new annuity plan for them with the same fund when you die. These options will affect the amount you are paid from your annuity when you are alive.
It is not possible to cancel an annuity once it is taken out. With the return rate on annuities dropping, it pays to shop around and consult an independent insurance adviser.
Who can purchase an annuity?
Annuities are normally purchased with the proceeds of a pension fund once you reach retirement. The maximum lump sum you can take from a pension fund is 25%; the rest must be invested in an annuity.
You do not have to purchase your annuity from your pension provider. This right to shop around is known as the ‘open market option’, which is sometimes shortened to OMO. Your provider should remind you of the opportunity to switch providers four months before you are due to retire and purchase your annuity, and again six weeks before the same date.
Remember to take into account any guaranteed rates offered by your existing provider as they can be worth taking advantage of. Guaranteed annuity rates are referred to as ‘GAR’ and are expressly defined in your contract. It is also very important to check whether any penalty charges apply if you are switching before or after your pre-planned retirement date.
If you have a small sum to invest (£10,000 or less) you will find that your options for purchasing an annuity are very limited, but some providers will able able to offer you a product nontheless.
This may depend on your age, gender, lifestyle and any medical conditions you have. If you have a serious condition, are overweight or smoke, there are special annuities which will pay more as your life expectancy is statistically lower.
How much will an annuity pay out?
Annuities are based on your life expectancy, so the amount you will be paid will vary. Insurers often take your general state of health into account, as well as your gender. This means that, in general, men will receive higher rates on their annuities than women, simply because women tend to live longer.
An annuity rate of 5% means that you will receive £5,000 a year on a £100,000 investment.
A rate of 8% would mean that you receive £8,000. Rates on annuities are very variable and depend on many factors. For example, it is possible to build in a certain amount of protection against inflation by opting for an annual increase in your income – some customers choose an annual increase of 3% for this reason. If you choose an increasing rate, the percentage figure you are quoted will indicate the initial return you can expect to receive.
Rates also vary depending on whether you wish payments to continue for a certain time after you die in order to support your family. You may also choose to set a guaranteed minimum period for payments so that the policy continues to pay out for a set number of years, regardless of whether you die in that time.
You may choose to have guaranteed funds paid out as a lump sum to your chosen party, but when paid at a lump sum the fund will be taxed – normally at a rate of around one third.
What if I am ill?
If you have a serious illness, you may be able to take out an ‘impaired lifetime annuity’. Unlike a normal annuity, this will pay out a higher amount as your life expectancy is reduced because of your illness.
If you are overweight or are a smoker, you may be able to take out an ‘enhanced lifetime annuity’. Again, this type of annuity will pay out a higher amount.
Can I avoid buying a lifetime annuity?
Unless you have a final salary pension, you must purchase an annuity with your pension funds before you are 75 years old.
However, you can choose to purchase a ‘temporary annuity’, also known as a ‘short term annuity’, if you wish. A temporary annuity normally lasts for no more than five years, at which point you can take out another or invest in a lifetime annuity instead. Temporary annuities are designed for people who wish to wait and see if rates improve before purchasing a lifetime annuity. As lifetime annuities cannot be cancelled, this may be a good option if you are not comfortable with the lifetime annuity rate you are offered.