An annuity is a product offered by insurance companies. Basically, you give the
insurance company the balance of your pension savings, after you’ve taken any tax
free cash, and the insurance company will pay you an income for the rest of your
life however long you live. This is called a 'pension annuity'. There are other
types of annuity.
If you have two or more pension pots it can make sense to bring them together into
one pension pot. For example, you could get a better annuity because your total
pension pot is higher. This process is called ‘consolidation’ .
A conventional annuity pays a guaranteed income for life that can never fall below
the amount payable initially.
A dependant is someone who relies on another person to support them financially.
There is a precise definition of who qualifies as a dependant for the purposes of
receiving a pension or lump sum on your death.
Defined benefit scheme
Defined benefit plans are often called 'final salary' pensions. This is because
they commonly provide a proportion of your earnings close to retirement. For example,
they may pay 1/60th or 1/80th for each year of service. Some plans calculate benefits
based on the average salary you receive over the time you worked for the employer.
Defined contribution scheme
These schemes are often called 'money purchase' plans. Money is usually paid into
the plan by you and/or your employer. At the point of retirement, you will have
a pot of money, based on how much has been paid in, plus any growth on the money
(less the costs of running the scheme).
Sometimes called lifestyle, impaired or underwritten annuities, these annuities
usually pay a higher income each year if you have medical conditions or lifestyle
factors that are likely to shorten your life expectancy. For example, high blood
pressure, smoking or poor diet (leading to overweight or obesity).
Fixed or increasing annuity
When you buy a conventional annuity, you will be asked to choose between a fixed
annuity and an increasing annuity. A fixed annuity will pay you the same amount
every year. An increasing annuity, as the name suggests, will increase each year
usually by a percentage (say 3% or 5%), or in line with the movement in an index
like the Retail Prices Index (RPI).
Fixed term annuity
These products aren't strictly annuities. They pay an income, but only for a limited
number of years – not for life. Usually, they are sold for periods of 5 or 10 years.
At the end of the fixed period, an amount of money is payable (called the 'maturity
value'), that can be used to buy an annuity that pays an income for life or, alternatively,
to buy another fixed term annuity or, depending on your circumstances, you could
choose one of the drawdown options.
A flexible annuity is effectively a form of investment linked annuity. That means
your money can be invested in a mix of assets including equities, but while this
gives potential for growth, the income you are paid each year can fall (though some
of these products offer a guarantee that your income can’t fall below a certain
Impaired life annuities
If you suffer from a medical condition like cancer, diabetes or high blood pressure,
for example, you can qualify for an impaired life annuity. This will usually pay
you a higher income.
Income guarantee period
When you buy an annuity you can elect for the income payable to continue to be paid
for a fixed period after your death. Commonly, people select either 5 or 10 years.
This means if you choose a 10 year guaranteed period, and die 3 years after buying
the annuity, the remaining 7 years payments would continue to be made. This is called
the ‘income guarantee’ option.
Joint life option
When you buy an annuity, you will be offered the choice of ‘joint life’ or ‘single
life’. If you choose ‘joint life’ part or all of your annuity payments can continue
to be paid after your death to your spouse or partner.
Your annuity can be paid monthly, quarterly or annually.
Payment in advance or arrears
When you buy an annuity you can choose to have your income payable in advance or
in arrears. For example, if you choose to have your income payable quarterly, would
you like it paid at the beginning of each quarter or the end?
Postcode annuities pay more if you live in certain parts of the country.
Single life option
If you choose a single life option when you buy an annuity the income payments will
not continue to be paid for the life of any spouse or partner after your death.
Tax free cash sum
You have the right to take a proportion of the pension funds you’ve built up as
a tax free lump sum after age 55. This will be limited to 25% of the total fund
(though it may be less than this if the total fund exceeds the Lifetime Allowance).
If you’re in a defined benefit scheme the formula is different .
If the total value of your pension fund savings in a defined benefit scheme is below a certain level (currently
£30,000), you can take the whole amount as cash. Only 25% of it is tax free.
Uncrystallised funds pension lump sum
This is a new way to access your pension savings. It basically means you can take a lump sum, or a series of lump sums, directly from your pension fund without having to buy an annuity or move into drawdown. The first 25% of any lump sum you take out is tax free, but the remainder is taxable.
Unit linked annuities
With a unit linked annuity your income in retirement will be linked to the investment
performance of the fund you’ve chosen. This means your fund value can rise and fall
in line with the underlying value of the investments in your fund. Some of these
products will provide some form of guarantee so you know, whatever happens to your
investments, your income can never fall below a minimum level.
It's possible to arrange your annuity so that whenever you die your estate will
receive all of your original investment, less the payments made to the date of your
These products offer a number of features, but usually pay a guaranteed income (commonly
around 4% of your capital at age 65) and still allow you to invest in a mix of equities
and other investments. However, please note that the construction of these products
does vary considerably from one insurance company to another.
With profit annuities
With profits annuities are invested in the company’s with profits fund. With profits
funds generally invest in a mix of assets (including equities). To try and avoid
sharp increases or decreases in the value of the fund, one of the distinctive features
of with profits is ‘smoothing’. This simply means the insurance company will hold
back some of the gains from investment returns in the good years to subsidise returns
when investments perform poorly. Like all lifetime annuities, these products will
pay you an income for life .
When you buy an annuity, if you select the payment in arrears option, and opt for
'with proportion', when you die your estate will receive the proportion still owed
to you to the date of your death. In other words, if you're paid monthly, and you
die in the middle of the month, half a month's income would be paid to your estate.