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Many people mistakenly think that an annuity is an investment. It is not. An annuity is a stream of income that you purchase with the funds accumulated in a personal pension plan. And, despite the drawbacks of these schemes, over half the workforce have a personal pension of some sort. In 1998 that amounted to over 10.2m people, so an annuity purchase is something that many of us are going to have to get to grips with.
Under current legislation, holders of personal pension plans have to buy an annuity before the age of 75. That is the law. You can't, unfortunately, take the couple of hundred grand built up in your pension fund on retirement and spend it in on whatever you fancy, whether that is a world cruise or Fat Chance in the 2:20 at Chepstow. The reason for this law is that the government wants to ensure that the money accumulated under the pension tax shelter goes to fund your retirement and not to enjoying yourself before falling back on the state for support in your dotage.
Now this has several implications, and people investing via personal pensions are not always aware of them. The first, and most important, feature is that an annuity stops when you do. On your death, or perhaps that of your spouse, the annuity income stops. As a result any residual money in that fund stays with the insurance company and does not form part of the estate that can be bequeathed to the next generation. It is true that you can take a 25% tax-free lump sum out of the pension on retirement when you purchase the annuity. But, that apart, any money you put into a personal pension plan can never ever be passed on the next generation. And all you will ever see is a monthly income cheque.
The second implication is that the stream of income you buy is not inflation-proofed. Even today's low rate of inflation of 2% still plays havoc with fixed incomes. While a £100,000 annuity might buy £8,000 of income today, in ten years' time that will only be "worth" £6,500 in money of the day. And these days people can be retired for twenty years. It is possible to buy inflation-proofed annuities, but they suffer two drawbacks. Firstly, they are expensive, and secondly the break-even point is only reached after a number of years. Because an annuity is simply an income stream, buying different types of annuities does not change the total amount you get, just the way you get it. In the case of inflation-proofing at, say, 5%, the initial income would be 40% less initially, then rising by 5% a year thereafter. So it would take 7 years to get the same level of income that you would have had with a straight annuity. And the additional income is probably more use early in retirement when mobility and physical fitness are higher.
The reason there is no growth in annuities is that on retirement the pension fund is invested in government bonds, commonly known as gilts. And because of that we can see the reason why falling gilt yields cause lower annuity rates. Interest from the gilts pays part of the income and the remainder comes from release of capital at a rate determined by actuaries who guess how long you are going to live. Ideally the last of the capital would be used on the day you die. So women, who live longer, get low incomes, and overweight smoking men get more because they won't be around for long. If you die early the annuity seller makes money, if you die late they lose money. These days people are living longer, and that adds to the downward pressure on annuity rates.
Although the maximum age to buy an annuity is 75, it is possible to buy one from the age of 50. With that flexibility comes a way of way of maximising the benefits from an annuity through either a phased retirement or an income drawdown scheme, or a combination of both. An income drawdown scheme allows us to draw income directly from the pension fund, at rates determined by the Government Actuary. A side-effect of this is that should the pensioner die during this period his estate gets the remainder of the pension fund, and that is not included in inheritance tax calculations. But if this scheme is combined with a phased retirement plan the pensioner can purchase the annuity in numerous discrete transactions over the period between retirement and age 75. Each time he or she does that they can take the 25% tax-free lump sum and, as the pension has got longer to grow, it should be a lot bigger.
In recognition of the restrictions imposed by annuities some insurance companies are offering a wider variety of annuities. These include with-profits, unit linked annuities, joint spouse and level guaranteed annuities that do pay out for a period after death.
As with all financial products it pays to shop around. There is no requirement to buy the annuity from the company that has managed your pension fund. In fact some of the variations can be as large as 30% as some firms target specific sectors.
Where Next?
Annuities are complex beasts, but The Annuity Bureau website is particularly good at helping to explain the whole business. And don't forget the Retirement Investing discussion board right here at the Motley Fool.