FOOL'S EYE VIEW
60-Second Guide To Annuities

By James Carlisle
October 14, 2002

Most people try to leave annuities at the very back of their consciousness and not to worry about them. But worry about them you must, since you have to buy them with most of the money you build up in most types of pension scheme (the ones that don't depend on final salary). Not only do you need to know about annuities if you have one of these pensions, but you need to know about them in deciding whether to get one of these pensions. You especially need to know about annuities if you're about to retire and actually get one -- getting the right annuity can make a huge difference to your retirement income.

So, for just the next 60 seconds, let the Fool gently ease annuities to the front of your consciousness!

0:57 What is an annuity?

That's pretty simple, for starters. At its most basic, it's a financial product that pays you an income for the rest of your life. You can buy it like any other product. In fact, as we've said, for defined contribution pensions, you have to buy them.

0:52 So when I die, my money goes up in smoke?

No! This is a classic misunderstandings with annuities. Your money goes up in smoke when you buy the annuity, just as it goes up in smoke when you buy a car or a packet of corn flakes. What generally happens when you die, is that your contract with the insurance company, and therefore your income, comes to an end. It was an income for life that you bought, so why shouldn't it end?

Annuities are products of a market place, so they all compete to give you as good an income as they can, safely, for the rest of your days. Because you buy the annuity and don't stand to get any money back, the insurance companies can afford to pay you a slightly larger income, safely, than you could get by investing your money yourself and keeping the capital safe to leave to your heirs.

So, for money that you want to save up and leave for your heirs, you need to look elsewhere. Annuities (and therefore pensions) are for providing an income, safely, for your retirement. Because they last for exactly as long as you need that income, they do that job pretty well.

0:40 Great! Where's the catch?

Safety is a funny thing with money, because exactly what's safe changes over different timescales. If what I want is a pint of milk tomorrow, then the safest way to make sure I can buy it is to have 35 or so pennies in my pocket. But if what I want is a pint of milk in 20 years' time, then who knows how many pennies I'll need. You can be reasonably confident, though, that a pint of milk will still cost roughly the same, relative to what people are earning. If you want something that will keep its value relative to what people are earning, then you're likely to do better by having something linked to the real economy -- for example the dividends that companies pay out.

On the whole (but see below for some exceptions), annuities promise to pay you a certain number of pennies each year for the rest of your life. That's very safe in terms of buying your pint of milk tomorrow, but not necessarily so safe in terms of buying your pint of milk in 20 years' time. In order to give you the safety in the near future, you have to sacrifice long-term returns, just as you would by investing in safe assets like cash and gilts, instead of shares or property.

That was absolutely fine when people typically retired at 65 and lived just a few years into their seventies. Nowadays, though, people are tending to live quite a bit longer than this. That makes for longer retirements and the longer your retirement is likely to last the less suitable an annuity becomes.

If you've got a defined contribution pension, though, then none of this changes the fact that you'll have to buy an annuity, so it's worthwhile shopping around to find a good one! Remember that you don't have to get an annuity with the same company that handled with your pension. In fact, you're very likely to get a better rate by goiong with a different company (excercising the 'open-market option').

0:21 Pheew -- just about got that! Can't they do anything to make it better?

Well yes they can. The standard annuity has been tweaked over the years, to provide a variety of different products. The most common tweaks are to make the annuity income increase with inflation ('index-linked annuities') or to make half of it continue after your death, paid to your partner, for as long as they survive ('joint-life annuities'), but there are many others.

The trouble is that all these tweaks need to be paid for with a lower starting income, because the fundamental problem of making a safe income last a long time is still there.

0:14 Annuities linked to the stock market

Increasingly, financial companies are aiming to deal with the problem caused by longer retirements by producing annuities that are linked to the stock market. This means that you lose some of the safety in your income in the short-term, in the hope of making it hold, or increase, its value better over the long-term.

The original product in this category was the with-profits annuity, but these suffer from the same lack of transparency as other with-profits products and that removes most of their appeal.

More transparent are unit-linked annuities. With one of these, the value of your income goes up or down, depending on the value of a particular unit trust. This carries a high degree of short-term risk but, over the long-term, you might expect the stock market to provide better returns.

Aside from the risks, equity-linked annuities suffer from the lack of portability that all annuities, as insurance products, possess. Insurance is something that needs to be set in stone between two parties at the outset because, after that, the odds might change. Neither you, nor your bookie, can get out of a bet half way through a horse race, because it would be against the other party's interests. In the same way, it wouldn't be fair for you to switch to a new annuity with a better rate if your life expectancy reduced, because you wouldn't like it if your annuity provider dumped you if it looked like you were going to live too long. It would rather defeat the point of the annuity.

So, once you've gone for a particular company, then you're basically stuck with it. That's one thing if the company owes you an amount of money each year that you can sue them for, but quite another with equity, or with-profits, funds where you might suddenly lose faith in the fund management company. It probably only makes sense to go for an equity-linked annuity if it's linked to something that's very well defined, such as an index tracker.

The Government is encouraging financial companies to come up with innovative new products, so we should hopefully see an increasing variety of annuity products in future.

0:03 Where can I find out more?

If that's just wetted your appetite on the mysterious world of annuities, then you can discuss them to your heart's content over on the Annuities discussion board. There's also a lot of information, including current prices, on the Annuities Bureau Website.