What is an annuity?
Essentially an annuity could be described as “a guaranteed income, paid to you for the rest of your life” (but possibly a fixed term – say 10 years for example if chosen). When you retire, you basically give away your pension savings (the amount you have in your pension) to an insurance company (the annuity provider) who in return pays the agreed income to you.
Basically, if you die too soon – you lose the extra money you paid out (to the insurance company), but if you are lucky enough to live to 100, you are quid’s in – simple! We call this “cross mortality subsidy” as the poor souls that die young effectively subsidise those lucky enough to survive! Simple eh?
Not so fast, like everything pensions, you will need to choose your annuity carefully so here we explain the other choices you need to make (upfront) when you agree your annuity:
You choose a “guaranteed period” to suit you, say 5 or 10 years for example, if you die during the chosen guaranteed period, the income will continue to be paid to your estate for the agreed fixed period of time.
Example: You die in year 2, your family receive 3 years-worth of remaining income.
THINK: If your income will definitely be paid for a period after your death, choosing a long-guaranteed period will reduce your income (on day 1)!
If you die, you can choose a specified percentage of the original lump sum you used to buy your annuity (known as the protected amount) to be paid to your estate. You may choose for example, 25%, 50% or 75% of the original income amount.
Example: You die in year 2 and chose 50% protection, your family receive (half of the lump sum given away to buy your annuity minus any income paid to you).
THINK: If you choose protection, as there is a chance money will be paid after your death, choosing any protection will result in reduced income to you on day 1!
When you die, would you like the payment to continue to a beneficiary, usually your spouse? You can usually choose a % to suit you but usually either 100% or 50% are common examples. When you die, if your spouse survives you they will then receive either 100% or 50% of your income for their lifetimes.
Example: You die in year 6 and chose a 50% spousal benefit. If your spouse survives, they will receive half of your income for the rest of their life!
THINK: Your spouse may outlive you. Therefore, choosing a dependents pension or higher spousal percentage will drastically reduce your income at outset given more will need to be paid out to spouse on your death!
Fixed or increasing/escalating?
You can choose a “fixed” income for life. Meaning it will remain level forever. In other words, if you are offered £500 per month, it will never go up to maintain your monies real spending power. An increasing or escalating annuity will go up, usually every year. You can usually choose a number of different measures including RPI, CPI or a fixed amount of say 3%.
Example: You choose fixed escalation of 2.5%. Every year your income will increase by 2.5% to try and offset the effects of inflation. You received £100 in day 1, on the anniversary this becomes £102.50 etc.
THINK: Where you choose an increasing annuity, the initial income that you are paid (on day 1) will be hugely lower than if you had chosen it to be fixed! Over time, it will increase though!
Monthly or annual annuity?
You can choose to receive payments from your annuity either monthly (like your wages) or yearly (in a lump sum).
THINK: As there is a small chance you will die part way through the period, the income will usually be slightly higher where you choose annual payment rather than monthly!
In advance or in arrears?
You can usually choose to have your income paid in advance or arrears. Where it is in arrears, you receive no income for the initial period (1st month or 1st year), whereas paid in advance means you will get the 1st payment immediately.
THINK: As the insurance company needs to pay your income “up front”, the income will usually be slightly lower where you choose in advance versus in arrears!
Other things to consider:
There are lots of insurance companies offering annuities so shopping around and using the “open market option” is vital to get the best deal! One provider may use statistics that believe you will die at 83 (on average) whereas another will have you dying at 85. Therefore provider 1 will be happy to pay you more as they believe you will not survive as long!
You can also but an “ill-health” or “impaired life” annuity, meaning if you smoke or suffer from diabetes for example, as your life expectancy is reduced, the provider will be happy to pay you more. Your postcode can also affect your annuity, those in Glasgow for example have some of the lowest life expectancy figures in the UK!
When your ready to investigate, get in touch with your dedicated experts and ensure your very own Financial Fortress!