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23 min read 6 Oct 21
An annuity is simply a way of providing a regular income. This is most typically to provide an individual with income once they have stopped working.
There are two basic types of annuity: Pension Annuities and Purchased Life Annuities (find out more in our article on Purchased Life Annuities).
Pension Annuities can only be bought with money/funds held within registered pension plans/ schemes.
In practice pension annuities fall into two types - lifetime annuities and scheme pensions. They are similar in that they provide an income for life but they have different rules. The differences are even more marked following the Taxation of Pensions Act 2014, which introduced Pension Freedoms.
Although historically we use the term "pension annuity" where the rules apply equally to the scheme pension and the lifetime annuity, great care should be taken as scheme pensions do not enjoy much of the flexibility now available (in legislation) for lifetime annuities.
A Scheme Pension is a pension income payable either from the scheme itself or from an insurance company selected by the scheme.
Defined Benefit schemes can only provide pension income via a scheme pension. If the member wishes to access the flexibilities now offered under lifetime annuities they must transfer their benefits prior to crystallisation. However, this action should not be taken lightly, please refer to our article on pension transfers and conversions, including DB to DC transfers .
See Finance Act 2004: s165(1), Pension rules 3
It is possible for a money purchase/defined contribution pension scheme to provide a scheme pension, but a scheme pension may only be paid if the member had an opportunity to select a lifetime annuity instead.
See Finance Act 2004: s165(1), Pension rule 4
Scheme pensions must:
The rules governing scheme pensions are generally more restrictive than those for lifetime annuities.
See Finance Act 2004: Sch 28, Para 2
Lifetime Annuities are payable by an insurance company where the member had the right to choose the insurance company.
The member's right to choose the insurance company is a key difference compared to scheme pensions.
Prior to 6 April 2015 the basic rules applying to a lifetime annuity required that:
After 6 April 2015, the basic rules applying to a lifetime annuity require that:
A section 32 buyout policy will usually provide a lifetime annuity because the member will be able to transfer it to another insurance company to pay the income – i.e. the member can choose the insurance company that ultimately pays the annuity. This assumes that where there is a Guaranteed Minimum Pension (GMP) entitlement, the pension plan has sufficient funds to meet the GMP amount. If the fund is insufficient to provide the GMP, the Section 32 will pay out a scheme pension.
The law is fairly restrictive on when it allows an amount of scheme pension to change. There is normally no room for variation (unlike with Lifetime Annuities) and the legislation states the circumstances where Scheme Pensions may be reduced or stopped.
There are several situations where a Scheme Pension may be reduced or stopped. These are:
PTM062340
A lifetime annuity may increase or decrease in line with any one or a combination of the following:
Conventional lifetime annuities purchased prior to April 2015 are annuities which do not decrease, or any falls are determined by regulations made by the Board of Inland Revenue.
After April 2015, you can still purchase annuities which don’t offer flexible income options, where these are offered by annuity providers. Choosing a non-flexible annuity would mean the Money Purchase Annual Allowance (MPAA) would not be triggered.
However, The Taxation of Pension Act 2014 details changes to new annuities that can be purchased post April 2015. From 6th April 2015, in addition to reductions determined by the Board of Inland Revenue, annuities can decrease by “allowed decreases”, which widens the circumstances in which annuities can reduce.
Notwithstanding the annuity design possibilities of the change in the post April 2015 legislation, detailed above, different annuity contracts may currently use different methods. The following methodology (old rules) will continue for annuities purchased pre April 2015 – this includes a post 6 April 2015 annuity set up as a result of a transfer of an annuity already in payment before 6 April 2015.
They can:
See Finance Act 2004: Sch 28, Para 3(1)(d) (as amended by the Taxation of Pensions Act 2014)
Finance Act 2005: Sch 10, Para 13(2) and (4)
The Registered Pension Schemes (Prescribed Manner of Determining Amount of Annuities) Regulations
2006 - SI 2006/568
Fully linked annuities operate just as it says. The annuity income will rise and fall based on the increase or decrease in the underlying investment or index. An example is an inflation-linked annuity.
Inflation-Linked Annuities
As the name suggests, inflation-linked annuities vary according to the rate of inflation. This is usually the retail prices index (RPI) but could also be the consumer prices index (CPI).
This provides protection against the effects of inflation – an annuity linked to RPI will increase by 3.8% in a year if RPI is 3.8% for that year. The change will usually apply at each one year anniversary of the date the annuity started.
The starting level of an inflation-linked annuity will depend to some extent on the provider's view of future inflation. The initial income amount may start higher or lower than a fixed escalating annuity depending on the rate of fixed escalation chosen. For example, an annuity increasing by 5% pa might have a lower starting income than an inflation-linked annuity, but one with a 2% pa fixed escalation may have a higher starting income.
POINT TO NOTE: the relative difference in the initial income amount of a fixed escalating annuity and an inflation-linked annuity will vary depending on economic outlook/circumstances and may change over time - it is important not to assume one will always start higher than the other.
In a period of deflation (i.e. negative inflation) an inflation-linked annuity may be expected to reduce. For example, if inflation is -2.4% in a year, the annuity would reduce by 2.4%. However, some inflation-linked annuities are written so that they will not reduce even where there is deflation - the annuity will remain at its previous level instead.
POINT TO NOTE: pensioner inflation (inflation for those who are older) tends to be higher than the general measure of RPI or CPI. This means that while an inflation-linked annuity may keep pace with inflation generally that does not mean it will keep pace with inflation for the individual.
Investment-linked annuities are those that can alter in accordance with:
The most common are unit-linked annuities and with-profits annuities.
While investment-linked annuities can, and do, use different underlying investments to determine the amount of annuity payable, they all operate using the same general principles:
POINT TO NOTE: the starting level of an investment-linked annuity will vary depending on the anticipated growth rate (AGR) chosen at the start. For a fund of £100,000 the starting annuity will be higher if an AGR of 6% is chosen as compared to an AGR of 2%. As a general rule, as the chosen AGR gets higher the starting annuity will become closer to the annuity provided through a fixed level annuity. It is usually possible to select an AGR that will provide a starting annuity of the same amount as a fixed level annuity.
The calculation of the annuity moving forward
Current level of annuity x (1 + actual growth rate)
(1 + anticipated growth rate)
For example, for an annuity of £10,000 pa with an anticipated growth rate of 4% pa and an actual growth rate of 6% in the first year, the amount of annuity at the start of year two would be:
£10,000 x 1.06 = £10,192.31
1.04
Investment-linked annuities do carry investment risk which neither fixed nor inflation-linked annuities have. This investment risk may help combat the effects of inflation, whilst also providing the opportunity for the individual's money to still be linked with investment performance. The client's income will vary in accordance with investment performance.
POINT TO NOTE: The difference in starting annuity, based on the anticipated growth rate (AGR) chosen, reflects the level of investment risk being taken. The higher the AGR, the higher the investment risk, the greater the chance of the annuity reducing in future, the lower the chance of it increasing in future. A balance has therefore to be struck between the level of risk a client is willing / able to accept, the AGR and the starting level of the annuity.
The difference between the actual and AGR over time can have a significant impact on the client's income, as the following example shows:
Annuity payments |
||||||
---|---|---|---|---|---|---|
2% Pa Growth |
4% Pa Growth |
6% Pa Growth |
||||
Year |
Annuity pa |
Annuity to date |
Annuity pa |
Annuity to date |
Annuity pa |
Annuity to date |
5 |
£9,074 |
£47,188 |
£10,000 |
£50,000 |
£10,999 |
£52,959 |
10 |
£8,235 |
£90,010 |
£10,000 |
£100,000 |
£12,098 |
£111,211 |
15 |
£7,473 |
£128,870 |
£10,000 |
£150,000 |
£13,307 |
£175,283 |
20 |
£6,781 |
£164,134 |
£10,000 |
£200,000 |
£14,636 |
£245,758 |
This helps to demonstrate the nature of the investment risk associated with investment-linked annuities - for those willing to accept the potential variation in income, the difference of the total cumulative income that could be provided from low to high potential investment returns can be huge - more than £80,000 in the above example.
POINT TO NOTE: investment-linked annuities can represent an attractive 'middle ground' in providing retirement income. They provide the opportunity for income to remain linked to investment performance without the annuity rate risk associated with income drawdown. This is particularly the case for those not wanting/needing the flexibility/death benefits that income drawdown offers.
Variable annuities can also offer an alternative 'middle ground' between conventional (fixed/inflation-linked) annuities and income drawdown.
In a similar manner to investment-linked annuities they offer the ability for a continued link between the annuity income and investment performance.
However, they go one step further than investment-linked annuities in that they can provide wider income limits, have greater income variability and allow for income reviews to be undertaken, all of which are similar in nature to the old rules that were applicable to income drawdown.
Variable annuities are not, however, able to replicate all of the death benefits permitted under income drawdown; in particular, they are not able to return a lump sum on death as income drawdown can.
The income from a variable annuity can be chosen from within a set range which is 50% - 120% of the amount of level annuity the fund could purchase with the variable annuity provider
If the variable annuity provider does not offer level annuities itself the limits will be calculated based on the average of three current market annuity rates for a level annuity. The individual may choose an income at any point between these limits and can vary the amount of income at any time agreed with the annuity provider, as long as it stays within the above limits.
The minimum and maximum income range/limits must themselves be reviewed by the annuity provider at least once every 3 years. That review will set the minimum and maximum for the period until the next review date.
Statutory Instrument – SI 2006/568 The Registered Pension Schemes (Prescribed Manner of Determining Amount of Annuities) Regulations 2006.
POINT TO NOTE: At the outset the fund used to calculate the income limits will be an actual pension fund but at future reviews it will be a notional fund. This is because an annuity contract does not have an actual fund value as such - if it did then it would not qualify as an annuity under tax law. The money has been used at the outset to buy the lifetime annuity but a notional fund value will be maintained and used when calculating the income limits at subsequent reviews.
When the amount of annuity has been chosen the same basic approach to investment returns, as that for investment-linked annuities, can be applied.
The notional fund is linked to underlying investments, such as a with-profits fund or unit-linked funds, and the value of that notional fund will go up or down in line with their investment performance. The annuity is paid from that notional fund and so will also impact its value.
If the value increases, the income limits at a review will also increase, thus increasing the maximum annuity that may be paid.
If the value reduces, the income limits at the next review will also reduce, thus reducing the maximum annuity that may be paid
It is therefore possible for the notional fund under a variable annuity to increase or reduce significantly depending on the level of annuity and investment performance.
POINT TO NOTE: this means that the level of investment risk associated with a variable annuity is higher compared to an investment-linked annuity. With an investment-linked annuity the amount of annuity previously paid out does not have any effect on the possible future annuity, but under a variable annuity it does.
POINT TO NOTE: variable annuities provide a solution to the lack of flexibility in being able to alter income, which is associated with other annuities. They provide a further step toward income drawdown although their inability to offer the same range of death benefits as income drawdown mean they will not be appropriate where death benefits are a key factor.
Conventional Annuities
As detailed above, prior to 6 April 2015, conventional annuities could not usually decrease. This limitation will continue to apply to conventional annuities purchased prior to 6th April 2015 (including where such an annuity is transferred to a new provider).
In respect to conventional annuities issued prior to 6 April 2015, they fall into one of two basic varieties:
A level annuity will pay the same amount throughout the period it is paid.
A fixed increasing (also known as an escalating) annuity will normally increase by a set percentage each year, on a compound basis. For example, an annuity starting out at, say £10,000 per annum might increase by 3% each year, to £10,300 in year 2, to £10,609 in year 3 and so on.
POINT TO NOTE: a level annuity will generally provide the highest starting amount of income as compared to most other annuities (variable annuities being a notable exception). This is because if increasing annuity options are incorporated, the cost of providing those must be met and that is managed by reducing the starting level of annuity income. So, an increasing annuity will have a lower, possibly much lower, starting income than a level annuity.
The risk of the amount of a conventional annuity reducing is very low - that would only potentially happen if the provider paying the annuity became insolvent. Even in that scenario the protection afforded by the Financial Services Compensation Scheme is 100% of the claim, with no upper limit.
POINT TO NOTE: This credit risk applies to all annuities, not just fixed annuities.
Inflation risks
The inflation risk associated with conventional annuities (and level annuities in particular) should not be overlooked. Level annuities can often be seen as carrying no risk but the gradual loss over time of the buying power of the annuity is a risk that should always be borne in mind. This is particularly true the longer the period over which the annuity is expected to be paid.
Inflation erodes the purchasing power of money over time - £100 in today's money will buy you less than £100 in, say, 5 years' time because of the effects of inflation on the cost of living.
So an annuity that is level will lose its value over time, where inflation is positive.
An increasing annuity provides some protection against this, although the level of that protection depends on the difference between the rate of fixed increases and the rate of inflation -– if the rate of inflation is higher than the rate of escalation, the purchasing power of annuity income will reduce in value over time and vice versa.
Protected Rights Annuities
Annuities paid from 'protected rights' pension funds were previously subject to some specific legislation.
These were:
The Personal and Occupational Pension Schemes (Protected Rights) Regulations 1996, SI 1996/1537
Historically there were greater restrictions on protected rights annuities, but these were reduced gradually over time. Protected Rights were abolished from April 2012, at which time the above restrictions also disappeared. On retirement, there are no longer any legal restrictions regarding the form of protected rights annuities and so all of the other options described above are available.
Protected rights annuities already set up will continue to operate on the basis they were set up.
Enhanced and Impaired Life Annuities
Enhanced Annuities are annuities that provide higher income amounts than a 'normal' annuity because of the individual having a lower than 'normal' life expectancy.
This reduced life expectancy could be due to long-standing lifestyle or health issues. For example, smokers, those with high blood pressure or relating to the specific health of the individual.
Enhanced annuities usually operate on the basis of a standard, higher, annuity rate being applied. For example, a smoker may get a set annuity rate, which is higher than for a non-smoker. There is no assessment of the individual's health as the enhanced rate is a 'standard' enhancement to the ordinary annuity rate.
Impaired life annuities are, however, specific to the individual. They involve an underwriting assessment of the individual in order to assess his or her life expectancy, based on his or her own health. A higher annuity rate might then be offered as a result of that assessment.
POINT TO NOTE: the terms 'enhanced' and 'impaired life' have tended to become mixed over time. The introduction of 'post code pricing' has not helped as these could potentially be regarded as 'enhanced' annuities. The terms are, perhaps, irrelevant, though as the most important point is could the individual get a higher annuity income because of his/her health.
There are 3 main factors affecting the amount of annuity income payable from the annuity purchase price:
This is linked to age, health and, until 1st December 2012, gender.
Annuities are a guarantee of an income for life, therefore the rates they're based on change as life expectancy increases. The younger people are when they retire, the longer they are likely to have in retirement and the longer the annuity is likely to be payable. For this reason, a 60 year old will generally receive a lower income than a 70 year old, if buying a lifetime annuity on the same date.
If the prospective annuitant, or one or both joint life annuitants or the dependant of an annuitant has a medical or lifestyle condition they may qualify for an increased income through ‘enhanced’ terms. This normally pays a higher income.
Until 21 December 2012 annuity rates could be based on gender. Generally, females received less income as they lived for longer. Since then annuity rates must be on a gender neutral basis by law.
Gilts are government bonds. The government issues gilts to raise money - in return they pay an amount of interest. In conventional Gilts this amount is fixed for the lifetime of the bond and is known as the coupon. For example, the government may issue Treasury 5% 2026.
This shows who issued the Gilt (Treasury), the interest rate to be paid (relative to the initial price) and when it is due to be repaid.
This means it has a coupon rate of 5% based on the initial nominal value of £100. £5 per annum will be paid out to the holder of the gilt until 2026 when the government will repay the £100 - a 5% yield.
After being issued by the Debt Management Office in the first instance, Gilts can then be traded on the secondary market where the demand for and supply of them will determine their value. If demand increases then prices rise so yields fall and vice versa. This means a good day for bond holders will see the asking price of their bonds go up but their running yield fall. Therefore a fall in bond yields is not necessarily bad news and may be good news depending on your objective.
In the example above, if demand caused prices to rise to £150 then the yield would fall to 3.33% (£5/£150). However, if the Gilt is held to maturity the government will repay the original £100 not the current market price (in this case, £150).
As well as those conventional Gilts discussed above there are index-linked gilts, double-dated gilts and undated gilts. Of these the index-linked is most common making up around 30% of the Gilt market. There are very few double-dated and undated Gilts remaining.
Annuity providers predominately buy gilts to match their annuity liabilities. Therefore, movement in yields will impact the annuity rates offered. Lower yields = lower rates and vice versa
There are many options available with annuities. They can be:
The more options added the lower the income will be. Likewise, the type of option taken has an impact. For example, a 15 year guaranteed annuity will pay less initial annuity than a 5 year guaranteed annuity and a joint life annuity where there is no reduction on death would pay less than one with a 50% reduction on death. (Please note that for annuities arranged after 6th April 2015 there is no limit on the guaranteed period that can be built into a Lifetime Annuity, subject to being offered by provider).
All things being equal:
Highest Annuity Payment |
Lowest Annuity Payment |
---|---|
single life non-guaranteed non-escalating paid annually paid in arrears |
joint life guaranteed (the longer the guarantee, the lower the starting annuity) escalating by RPI* paid monthly paid in advance with overlap
|
*The actual cost of the escalation would depend on the escalation amount. RPI escalation is not necessarily the most expensive.
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