Your Financial Architect’s Guide to Annuities
What is an Annuity?
An annuity is an investment sold by insurance companies. It
is a way of converting a lump sum, usually a pension fund
built up during your working life, into an income for the
rest of your life. Unlike other investments, it cannot be
used up - however long you live.
Why do I need an annuity?
Current legislation dictates that most people must purchase
an annuity with their personal pension and stakeholder pension
funds between the ages of 50 and 75 (55 and 75 from 2010).
Often you can take up to a quarter of your pension fund as
a tax-free lump sum, although the exact amount will depend
on the type of pension that you have.
The income payments (usually monthly) from this type of annuity
are taxed as earned income and are usually paid to the recipient
net of basic rate tax. Higher rate taxpayers may be liable
for additional tax which at present has to be collected separately.
It is usually a good idea to take the lump sum from a pension,
although there are circumstances when it might be better not
to take the lump sum (e.g. if there are high guarantees on
conversion to an annuity). Many people invest their tax-free
cash elsewhere, either to provide a greater income or for
capital growth.
Purchased Life Annuities
You may wish to use your tax-free cash or any other funds
that you have built up to purchase this type of annuity. This
is similar to a pension fund annuity (compulsory purchase
annuity) but is taxed more favourably and should therefore
provide more income £ for £. Remember though,
once you have purchased your annuity you cannot normally convert
it back to cash.
There are different types of annuity arrangements that are
briefly listed below:
Level without guarantee
The income payments provided are the same each year throughout
the recipient's life.
Level guaranteed 5 or 10 years
The income payments are the same each year but are guaranteed
to be paid for a minimum of (5or 10) years even if the recipient
dies within (5 or 10) years. The balance due will be paid
to the estate of the recipient.
Escalating X% p.a.
The income payments increase each year by X% compound but
cease immediately on death. X% is normally 3%, 5% or RPI.
Joint life last survivor
On the death of the first life the income passes to the second
life or survivor and ceases on the death of the latter.
With overlap
If one of the recipients dies within the guaranteed period,
the balance of the guaranteed income is paid as a lump sum
(sometimes discounted) to the second life who will receive
the income from the annuity in his or her own right
Value Protection - a new benefit should you die before
age 75
People are often concerned they may not see the full value
from their annuity if they pass a way in the early years -
value protection means this eventuality is taken care of.
A lump sum can be paid out in the event of death before age
75 but you are also safe in the knowledge that income will
be paid out for life, even if that is longer than you had
planned for financially.
You can choose to protect up to 100% of the value of your
pension fund. Adding value protection will reduce your pension
income and you need to be sure that you can still meet your
needs.
Deferred Annuity
These annuities are purchased with a lump sum or series of
payments to commence at a future date for a specified term.
Equity Linked Annuity
The underlying value of the annuity is unitised enabling the
annuitant to withdraw some units each payment period with
the balance remaining in the fund going up and down as the
fund value varies with market movements.
With-profits annuities
These link your income directly to the performance of the
insurance company's with-profits fund. Typically, your income
is made up of two parts:
A minimum starting income
This is usually set at a low level but, unless investment
conditions are very bad, you will usually get at least this
much income. Some with-profits annuities guarantee it.
Bonuses
The insurance company usually announces bonuses each year.
Bonuses can be 'reversionary' (usually announce once a year
and guaranteed to pay out for the duration of your annuity)
and 'special' - these only pay out a year or so until the
next bonus announcement. The amount of any bonus depends on
many factors, the most important of which is stockmarket performance.
Some insurance company's may guarantee a bonus rate, for example
3% a year. Sometimes you can choose the guaranteed rate, but
the higher the guarantee, the lower your starting income
Enhanced Pension Annuities
Some insurers are prepared to pay a higher income than usual,
for various categories of people, because they assume the
payment period will be shorter than average. Smokers, people
with certain health problems and from selected occupations
should consider enhanced pension annuities.
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