Annuities explainedAnnuity types

Value protected annuities

You can choose to return the money to your estate when you die, or take a risk and invest it in the stock market

April 2006 saw the introduction of value-protected annuities - a more explicit version of a guaranteed annuity.

With a value-protected pension annuity, if you die before age 75, your built-up fund is returned to your estate less any income that has been paid out and 25% tax.

Impaired/enhanced life annuities

As annuity rates are tailored to average life expectancy, some companies will offer a higher rate to those with a lower life expectancy – if you have a health problem for example. These are known as ‘impaired life’ or ‘enhanced life’ annuities.

It is estimated that up to one in three of us could qualify for one. You might qualify if you have severe health problems, such as a history of heart disease or cancer. They may also consider a higher annuity rate for heavy smokers or people who are overweight.

You usually have to go through an IFA to get one, however the application process can be lengthy – they are individually underwritten and you'll probably need medical information from your GP, as well as extra tests.

Investment-linked annuities

Investment-linked annuity products will allow you to tap into any potential returns you may not receive if opting for a more standard annuity.

You still have to hand over your fund in return for an income, however you stand to benefit from future stock market growth. Be warned that, as with all stock market-linked investments, there are no guarantees that returns will improve or that your income will rise.

With-profits annuities

These work like any form of with-profits investment. The returns on your investment are smoothed out over time. In good years, some of the return is held back, allowing more to be paid out in bad years.

When you take out a with-profits annuity, you choose an anticipated bonus rate (ABR). The level of your income depends on how the ABR compares with the level of bonus the insurance company declares. If you choose an ABR of 3%, and the company declares a 5% bonus, then your income rises. If the declared bonus is only 1%, your income falls.

Annuities with the highest ABRs pay the highest initial incomes, but the higher the starting income, the less chance there is that it will increase in future.

For added security, some with-profits annuities offer a minimum guaranteed income, regardless of investment growth.

Unit linked annuities are similar in structure to unit trusts

Unit-linked annuities

With unit-linked annuities, your money is invested in a unit-linked pension fund which works along the same lines as a unit trust. Your income varies depending on the value of the stocks, shares and other assets that your units represent.

You can switch between your provider's different funds if you want to change your investment strategy. But remember that switching funds can mean higher costs. Experienced investors might prefer a self-invested unit-linked annuity, which gives you more control.

Unit-linked annuities are more volatile than with-profits annuities because your investment returns aren't smoothed out over time. You should consider them only if you have a very adventurous attitude to risk, can cope with a fluctuating monthly income, and have other sources of income.

Purchased life annuities

While this product will give you an income for life, this is not a pension annuity – one you buy with money from your pension pot. You buy it using a cash lump sum, your savings for example, however your options are limited to a conventional annuity as opposed to an investment-linked one.

As with all conventional annuities you have to decide whether or not you want your income to rise and whether or not you want the annuity to just cover you, or a partner as well.

A big difference is that you can choose to buy a purchased life annuity where your capital is fully protected rather than just a guarantee. Taking one of these out means that when you die, the remaining money is repaid to your estate and so can be passed to your heirs. However if the gross income paid out is greater than the amount invested, your heirs receive nothing.

Tax on purchased life annuities

Additionally, only part of the income is taxable. This is because the tax system treats part of the return paid to you as a repayment of the lump sum you invested.

The taxable part of the income from a purchased life annuity is taxed at 20% - this is usually deducted before you get it. Basic-rate taxpayers have no more tax to pay, but higher-rate taxpayers must pay a further 20%.

Non-taxpayers can either have the taxable part paid gross or reclaim the tax by filling in form R89 from the annuity provider or your tax office. Starting rate taxpayers can reclaim half the tax deducted.

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