An annuity is a common form of pension investment for retirees. Below we will answer the following questions;

Annuities provide the holder a form of guaranteed income for the a set period of time, usually until death, in exchange for a lump sum. The level of income may or may not rise to account for inflation
An annuity is one type of product offered by financial institutions, typically insurance companies. They use actuarial mathematics to establish mortality rates i.e. how long a person is likely to live. They then apply this information along with expected investment returns (gilt yields), and profit margin to establish an annuity rate
Annuity rates are the exchange rate offered by a financial institution for guaranteeing you a set level of income for the rest o your life. They are typically expressed as a percentage or an amount per £/€/$ 100,000.
As an example, an annuity rate of 6.5% would entitle you to an initial annual income of £6,500 per £100,000 lump sum paid. This may then rise depending on the annuity option chosen
Pensions, what is an annuity & how do annuities work

Benefits of an annuity

  • No risk of you outliving your pension provisions
  • The level of income you will receive is known which could help you to budget better
  • Ability to choose how frequently you receive your income
  • Option to have income payments rise in line with inflation or at a fixed rate
  • Option to have a joint policy to include your partner

Drawbacks of an annuity

  • Loss of capital – unable to pass anything to heirs or dependants
  • Potentially expensive
  • Potential to receive back far less than you paid if you die early
  • Real income level may diminish over time
  • Inability to sell in the future
Each of the following are variations of the basic principle of an annuity i.e. that in exchange of a lump sum cash payment the holder is guaranteed an income for life.

The annual income is fixed for the duration
The initial income will increase on an annual basis by an escalating factor. Common forms of increases include by an inflation measurement or by a fixed percentage
Income will be paid up until the policy holders death
Income will be paid until both the policyholder and their spouse have died
You invest a lump sum which guarantees a minimum income that will be paid. The exact level of income you receive will fluctuate according to the underlying investment performance. The two main forms are investment linked and with profit bonds.

Investment linked annuities

Part of an annuity will be invested to hopefully generate additional returns. These are subject to the vagaries of investment performance therefore your annual income can fluctuate accordingly

With profit bond annuities

As with investment linked annuities your annual income can vary though this should be less obvious compared with investment linked options. The reasoning is that with profit bond investments withhold part of the profits in good years to increase the returns in bad years thereby smoothing overall returns

If you are considering either form of investment linked annuities you may wish to create your own by buying an normal annuity for the guaranteed section and leave the remainder invested in your pension. This way you can take advantage of the current pension rules to withdraw extra income only when you require it. Also, on death the remaining fund can then be passed on to your heirs

Income is paid for a fixed duration and, at the end of the term, you will receive a lump sum (known as the maturity amount).
Higher income payments will result in a lower final payment at the end of the period
One of the factors for calculating an annuity is the life expectancy of the policyholder. Poor health can therefore entitle you to a higher annuity rate. If your lifestyle or health can realistically negatively affect your life expectancy then you should always apply for an enhanced annuity. Some of the main conditions that could result in a higher annuity rate include;

  • Smoking
  • Cancer
  • Diabetes
  • Heart disease
  • High blood pressure
  • Overweight
As mentioned, annuities provide a guarantee to the level of income provided over a defined period (usually until death). This guarantee may prove expensive to some people so what are the other options available?
Following the recent change in pension legislation there are no limits to the level of income that can be withdrawn from a pension pot in retirement. That leaves a possibility that the retirement savings will be depleted before death. To ensure this isn’t the case you can buy an annuity or;

Create an income generating investment portfolio

By selecting investments which pay income via dividends (shares) or interest (bonds) you can create an retirement portfolio which should generally maintain it’s value. The advantages of this option is that share dividends typically increase over time, often at a rate in excess of inflation, the underlying investment value tends to increase over time as well, and your underlying investment can be passed on to your dependents upon death. The main drawbacks revolve around the fact that the investment performance has no guarantee, therefore your income and investment value can reduce, and your initial income payments may be lower than that offered by an annuity. Another disadvantage is that to achieve an equivalent income stream as offered by an annuity you may inadvertently take more risk than you are aware of in this period of abnormally low interest rates

Buy inflation linked government bonds

Purchasing inflation linked bonds gives a guarantee that your income and initial investment will keep in line with inflation. Unfortunately, in the current economic climate the interest paid from these forms of government debt are likely to be substantially below what will be offered by an annuity. Warning, in the longer term interest rates will rise to more normalised levels. Purchasing inflation linked bonds will not allow you capitalise on higher future rates unless they mature. One option to safeguard against this is to have varying length bond maturities so that shorter dated ones can be replaced with higher interest rate versions though doing this will reduce the level of interest you will receive (Typically longer dated bonds pay higher interest than shorter dated bonds)