What is an Annuity?
To ensure a pension pot flexibly lasts for the duration of any given retirement period, the best option is usually to hold it in a form that will provide a regular income, ideally without depleting the pot’s base value. While building up a pension pot, returns earned from assets the cash has been invested in are ploughed back into the pension in the form of compounded returns. Over a longer period of time, all or a large portion of a working lifetime, this has a very powerful impact on building up the pot’s final value.
However, once retirement age has been reached and a pension comes into active use, the returns generated by the pot’s investments are what provides a steady income for the retiree(s). While paying off and outstanding debts, if they exist, or investing in things such home improvements are not necessarily a bad way to spend a portion of a pension pot, it is also important that the capital which remains is sufficient to provide enough income for the holders to live comfortably from.
Buying an annuity with all or a part of a pension pot is one of the options available to pensioners when it comes to securing this regular income stream. An annuity is an insurance product which is bought for a one-off lump sum. The annuity holder then receives a regular annual income from the annuity provider. Depending upon the choice of the annuity product purchased, this regular income is usually fixed, though can also be variable and will either be for life or for a fixed maximum period of time.
The value of the annual income that an annuity provides is referred to as the ‘annuity rate’. The rate offered will depend firstly on the size of the lump sum you are able or wish to commit to buying the annuity. As a general rule, the more expensive the annuity the higher the annuity rate will be.
Because an annuity is an insurance product, the rate will also vary in accordance with the provider’s assessment of your likely life expectancy. This is done in a similar way to if you were purchasing health insurance.
The insurer will assess your current health, any past or current health conditions, your lifestyle (eg. are you a smoker, do you take regular exercise?) and family health history. The difference between health insurance and an annuity is that while the worse your health is considered to be the more you will be charged for health insurance, the better your health is the more you will be charged for an annuity! This is for the simple reason that the longer you live the longer the annuity provider will be obliged to pay you your annuity rate.
Delaying an Annuity Purchase
The cut off age for buying an annuity used to be 75 but there is no longer any upper age limit. As a result, some pensioners who intend to eventually invest in an annuity defer doing so until later in their retirement. This could be for numerous reasons such as expecting that annuity rates on offer will improve in the future.
Annuity rates are influenced by interest rates and higher interest rates have historically meant more attractive annuity rates. This is because the annuity provider may well invest part of your lump sum in debt such as corporate and government bonds.
Another reason why an annuity purchase might be delayed is because an individual wishes to stage the flow of their spending level over different periods of their anticipated retirement trajectory. A typical pattern of retirement is that over the first several years pensioners are most active. While health and energy levels are good retirees often wish to travel, make home improvement and spend time on hobbies and other activities they didn’t have the same opportunity to enjoy while working full-time. During this first stage of retirement, finances allowing, retirees may actually have higher expenditure than while working.
During the second stage of retirement pensioners would typically expect to have settled into more of a domestic routine and live a little more slowly. Hopefully their health will still be reasonably good and an active lifestyle can still be enjoyed but the most common pattern would be that a slowly changing lifestyle will lead to lower expenditure. As a pensioner ages and health may start to become more fragile and energy levels drop, the amount spent would also be expected to naturally taper.
Delaying the purchase of annuity to perhaps the ‘second’ phase of retirement is one way to strategically manage the cash flow provided by a pension pot. A later annuity purchase is one way to ensure a pension both last for as long as it is needed while providing greater spending flexibility in the first years of retirement.
However, there are also annuity products that can be purchased earlier but still offer the option for payments to be delayed for a fixed period of time or until the holder wishes to start receiving them.
There are quite a number of different kinds of annuity available on the UK market, each best fitted to a different set of financial considerations or personal circumstances. A delayed annuity is just one such option. While this is not an exhaustive list and various hybrids and variations on these main categories are available, most annuity products fall into the following categories:
- Deferred Annuity: already mentioned, a deferred annuity is bought now through either a lump sum payment or regular instalments but receiving regular income via the annuity rate is put off for a number of months or years.
- Lifetime Annuity: the standard annuity format, a lifetime annuity provides a regular income for as long as the holder lives. The annuity rate paid out by a lifetime annuity will either be fixed, escalating or enhanced as described below. A slight variation on a lifetime annuity is an ‘immediate lifetime’ annuity.
The only real difference between the two is that while a standard lifetime annuity must be purchased directly from funds held within a pension pot, an ‘immediate lifetime’ annuity can be purchased with funds from another source such as the sale of a property or non-pension savings.
- Enhanced Annuity: this kind of annuity is available to those who have a specific health condition or lifestyle, such as being a heavy smoker or drinker. If the purchaser has strong grounds to argue that their life expectancy is very likely to be significantly lower than average, supported by unbiased medical opinion, they can apply for an enhanced annuity which would offer a higher than normal rate.
- Guaranteed Annuity: this kind of annuity is a variation on a lifetime annuity with the clause that if the holder were to pass away within a predetermined period after the start of annuity rate payments, usually 5-10 years, the rate will continue to be paid to the benefit of nominee(s) for a guaranteed period.
- Fixed Term: in contrast to life and guaranteed annuities a fixed term annuity pays out the annuity rate for an agreed period of time, such as 5 or 10 years. If the holder passes away during the period of the fixed term payments will stop but they will also stop after term regardless of whether the holder is still alive.
- Increasing Annuity: the annuity rate is linked to inflation or a fixed annual rate of increase independent of inflation as agreed upon at the time of purchase.
- Level Annuity: the annuity rate remains stable throughout the duration of its payment.
- Variable Annuity: also sometimes referred to as an ‘investment linked annuity’, variable annuities are a higher risk, higher return option. The annuity rate will be linked to investments such as a fund, or basket of investments and will vary depending on performance. As long as financial markets are healthy this would be expected to result in a better annuity rate than normal but also means the rate could fall significantly in the event of a financial markets crash or downturn.
- Single Annuity: retired couples who have decided to purchase an annuity have to make a choice between one or two single annuities or a joint annuity (covered below). A single annuity is linked only to the life of the holder and annuity rate payments, unless a guaranteed annuity, will cease upon the death of the holder. This means that the remaining partner will no longer receive any annuity payments. The advantage of a single annuity is that the annuity rate is higher than for a joint annuity.
- Joint Annuity: while the annuity rate will be lower than the equivalent paid out by a single annuity purchased for the same value, payments will continue to be made if one partner passes away. One caveat to that is the surviving partner will in most cases be eligible to receive a reduced percentage of the original joint annuity rate after this point.
As with any product, annuities have their strengths and weaknesses in comparison with other options available to pension holders who wish to secure a regular income from their pot.
- Guaranteed income: the primary advantage of an annuity is the security it provides by guaranteeing a regular income that is not linked to fluctuations in the financial markets and investment performance. Variable annuities are one exception to this but even if financial markets drop a level of income is still guaranteed.
Most other investment-based pension options offer no similar guarantee with pensioners accepting the risk that a market drop could result in a loss of value to the underlying pot. In the case of lifetime annuities, the most common kind, the income is also guaranteed for as long as the holder might live. There is no chance of the income drying up over the years.
- Inflation proof: with the exception of ‘Level’ annuities, annuity rates are also tied to inflation so the holder will not see a reduction in purchasing power through inflation over the years. This quality of annuities is particularly valuable should a period of high inflation occur over the retirement period.
- Care requirements covered: some kinds of annuity include the mechanism of a rising annuity rate at the point the holder might require care costs to be covered. This can be an increase of up to 65%.
- Price Premium: because annuities provide a guaranteed income for the lifetime of the holder, this security costs a premium. As with any insurance product, if all is well such as financial markets performing steadily and retirement conditions, expenses and duration fall within expectations, the holder will sustain a loss.
Annuities come into their own when things do not go exactly as hoped for or expected. If someone takes out phone insurance and the phone remains safe and sound that investment is lost. However, if something does happen the insurance holder realises a financial advantage in comparison to someone who decided to hope for the best.
If there is a serious financial markets downturn or the holder lives to a riper old age than anticipated an annuity holder will be better off than those who have chosen investment-based income pension products.
- Irreversible decision: once an annuity has been purchased the holder is locked in. An annuity cannot be sold and the cash then reinvested in an alternative as is the case with many other kinds of pension product.
- Not inheritable: unlike investment-based products whose remaining value can usually be passed down when the owner passes away, an annuity cannot. Though a guaranteed or joint annuity might continue paying out the annuity rate for a number of years, in the case of the former, or for the duration of a surviving partner’s lifetime, in the case of the latter, annuities are broadly tied to the lifetime of the holder.
- Available rates fluctuate: the level of annuity rates available on the market fluctuates depending upon market conditions. If the kind of investments annuity providers put money into are not performing particularly well at the point you reach retirement and wish to purchase an annuity, lower rates will be on offer.
When Might an Annuity be the Right Pension Choice?
Purchasing an annuity with all or part of a pension pot is a decision that should be made based on personal circumstances and evaluation of what the prospective holder’s needs will be during retirement. An annuity de-risks retirement income but at a price. One major consideration is if a pension pot is large enough to buy an annuity that will provide a rate sufficient to live from during retirement. A careful decision should be made as to whether the security an annuity provides compensates for a reduced income that is not at risk to external financial market factors.
Delaying an annuity purchase or splitting a pension pot between the security of an annuity and more lucrative risk-based investments is also an option. Anyone who does not feel confident in being able to fully assess the pluses and minuses of the different income producing pension product options available to them should consult with a certified financial advisor.