Annuities How an annuity works
What is an annuity?
Quite simply, an annuity is a financial product which provides you with an income for life in return for a lump sum.
Annuity rates are set by insurance companies and typically expressed as a sum per £10,000 or £100,000 of lump sum. So, for example, a 65-year-old man might be quoted an annuity rate of, say £700 income for every £10,000 lump sum.
The major drawback of an annuity is once you've handed the money over you can't get it back, and if you die soon after buying the annuity then the income you receive won't be anywhere near the amount you have paid in. However, there are steps you can take to protect yourself.
Who needs to buy an annuity?
Anyone who has a lump sum and wants to convert this into an income can buy an annuity, but most people come across annuities for the first time when they're coming up to retirement and need to convert part of their pension fund into an income.
You'll need to buy an annuity with funds from any personal pensions, stakeholder pensions and most money-purchase employer schemes. The type of annuity you buy with your pension fund money is called a compulsory purchase annuity. We also refer to these as pension annuities.
If you belong to an employer's final salary scheme, your pension is usually paid directly from the scheme so you don't have to think about getting an annuity. With some money purchase pension schemes from employers, the pension trustees may buy an annuity for you. Find out what your options are from your scheme manager.
A level or an increasing income from my annuity?
To work this out you will need to decide whether or not you want your income to increase each year. You can buy an annuity that increases with inflation, or one that's set to rise by a fixed percentage each year. Alternatively, opt for a level annuity, which will provide exactly the same income each year.
Single or joint life annuity?
The next decision is whether you want an annuity that covers you alone, or an annuity that protects your partner as well.
A single life annuity pays you an income until you die, but if you're part of a couple and die first, this could mean that your partner is left short of money. A joint life annuity continues to pay some or all of the annuity income to your partner when you die.
There are of course some trade-offs for a joint annuity's extra provision. Because a joint life annuity will continue to be paid after you are dead, the rates offered are lower. The higher the proportion of your annuity income that you choose to be paid after your death, the lower the initial income paid by your annuity.
And if your partner is younger than you, the insurance company will offer a lower annuity rate, as they expect to be paying out the annuity for longer.
Where an annuity has a guarantee period, it will be paid out for a set time period, usually five or 10 years, even if you die during that time. If you do die during the annuity's guarantee period, the payments may continue as an income to your survivor(s) for the remainder of the annuity period, or sometimes can be rolled into a lump sum.
An annuity with a guarantee is sometimes seen as a substitute for a joint life annuity. But it's not the same, as the maximum annuity guarantee period is only 10 years. As a result, an annuity guarantee won't fully protect your dependants in the long-term.