Conventional / Lifetime annuities

According to the FSA*, most people buy a lifetime annuity with their pension funds.

Before you buy a lifetime annuity you’ll have to decide what type and benefits you want.

It’s advisable to start thinking about your annuity choices at approximately four months before your intended retirement date.

There are different types of lifetime annuities to suit different needs and circumstances.

If you have more than one pension plan or scheme, you might get a better income by combining them, although this is not always the case and you don’t have to use them all at the same time.  This can be complicated decision so it may be a good idea to get financial advice from experts such as Annuity Arrow. 

We can assess your circumstance and assist you with your decision.  We also search the market for you to find better annuity rates.

How lifetime annuities work 

A lifetime annuity is a contract with the insurer/annuity provider that, as the name suggests, lasts your lifetime.  It pays you an income for the rest of your life. If you die within a short time after buying your annuity, you won’t have received much income from your investment. However, if you were to live to a very old age, you would get a lot from your investment.

You buy lifetime annuities from life insurance companies or other financial institutions. When calculating their annuity rates (the level of income they will pay you) they take account of the fact that some people live longer than others. People who live longer than average will take more from their annuity than, for example, someone who dies three or four years after retirement. People who die early subsidise the annuity rates for those who live longer. Insurance companies adjust annuity rates because average life expectancy is rising.

Interest rates also affect annuity rates because insurers base annuity rates on the return they get from their own investments. Once you buy an annuity you are locked into the annuity rates offered at that time. You won’t be affected if annuity rates fall, but neither will you benefit if annuity rates increase.

How lifetime annuities pay out

The annuity rate and the amount of income an annuity pays depends on many different factors. Some insurers place more of an emphasis or weighting on some factors than others. Some insurance companies consider factors that others don’t.  This can work either for or against you, which is why it is sensible to use Annuity Arrow to search the market for you to find a better deal and secure you more income. It is the same principle as finding the best deal for your home or car insurance.

Some of the factors that insurers take into account when setting their annuity rates or deciding how much income they will pay you.  This is not an exhaustive list:

• the size of your pension fund;

• the amount of tax-free lump sum you take;

• whether you have used your fund to contract out of the additional State Pension

• your age;

• your sex;

• your health;

• your smoker status;

• the additional benefits you choose such as escalation or spouse’s pension

Some insurers are considering using your postcode as a factor to determine your annuity rate. The argument behind this is that some parts of the UK have a far higher life expectancy than others.

Usually the starting income from the same size of pension fund is higher for a man than for a woman of the same age. This is because, on average, a woman is likely to live longer than a

man of the same age. The older you are when you buy an annuity, the higher the income you are likely to get at the start. This is because, on average, an older person has fewer

years left to live than a younger person so the insurer can afford to pay you a higher income for the remaining years it expects you to live.  You must take care when considering delaying buying your annuity to get a higher rate. Age is not the only factor taken into account so a change in another variable, such as interest rates or a reassessment of life expectancies could actually mean you end up with less income.

Payment of annuities

You can usually choose to have your annuity income paid every month, every three

months, every six months or once a year. You can also choose if the payment is made in advance or arrears.  You can expect less if opting for advance over arrears.

Taxation of lifetime annuity income

Remember that the income from a lifetime annuity is taxable in the same way as earned income.  It is normally taxed at source by the insurer in the same way as Pay As You Earn (PAYE) tax is deducted by an employer. 

If the total income you receive, including that from your annuities is less than the current personal taxation threshold, you income will not be subject to income tax.

Single-life and joint-life lifetime annuities

Lifetime annuities can be single life or joint life. Unless there is a guarantee, a single-life annuity will only pay out during your own lifetime. A joint-life annuity continues to pay an income to your partner after your death in retirement.

You can usually choose between a joint-life annuity that pays your partner the same as you were receiving, or a reduced amount, such as two thirds or a half of what you were

Receiving prior to death.

Not all insurers pay out to partners if you are not married.  Some insurers do not pay out to surviving partners from homosexual partnerships. Please make Annuity Arrow aware of your circumstances if you want a partner to receive an income from your annuity in the event of your death and you are in an unmarried or homosexual relationship.  Annuity Arrow is non discriminatory and needs this information to ensure our clients’ needs are met.

Joint-life annuities are more expensive than single-life annuities because the insurance company will expect to continue paying the annuity for longer.

Level and escalating lifetime annuities

You can also choose for your lifetime annuity to be level or escalating.

If your pension is level, you will get paid the same amount each year. If you choose escalating, it will increase each year by the chosen amount. The escalation amount is normally a fixed percentage, say 3%  or the Retail Prices Index (RPI).

A level annuity has a higher starting income than escalating annuities but how much you can buy with the income from a level annuity falls over time as prices rise and inflation kicks in. To protect your income from rising prices and inflation, you can choose an escalating lifetime annuity, which pays a lower initial annuity but then increases each year.  According to the FSA*, it would take around 14 years for the 3% escalating annuity to catch up with the level annuity and it ould take 26 years before the total you received from the 3% escalating annuity exceeded the total paid by the level annuity.

Escalation can be applied to single and joint life lifetime annuities.

Guarantee Periods

You can opt to have your pension income guaranteed for a period of five or ten years.

If you were to die before the end of the chosen guarantee period, the remaining pension income not paid for the period would continue to be paid to your estate.  On some occasions, the insurance company may allow for the remaining income to be paid as a lump sum.  This lump sum is normally less than the total value that would have been paid as an income to reflect the insurance company paying the money sooner.

Cost of Ancillary benefits

It is important to remember that whilst the ancillary benefits detailed above, like provision for a partner on death, escalation and a guarantee period are desirably to many, they are not free and come at a cost. Therefore, it is important to decide what is really important and where your priorities lie before committing to an annuity.

The most immediate income is available from a single life annuity. Any of these extra benefits that are chose have the effect of reducing the income paid on commencement.

* Source = FSA moneymadeclear retirement options Nov 2007 factsheet