Annuity Guide
An Annuity is a contract where the person who pays for the annuity (the annuitant) will receive a set amount every year for a certain period. Despite the name annuity, the payments may be made monthly and the cost of the annuity will depend on the likely length of time for which it will be paid.
Most annuities are bought for a lump sum, i.e. single premium, and start immediately – known therefore as immediate annuities. Regular premium annuities are also available.
Annuities are normally expressed in terms of annual amounts payable, though in practice, they can be payable monthly, quarterly, half-yearly or annually. An annuity can be paid in advance or arrears, for example, where an annuity is effected on 1st January 2003, the first annual payment is due on the same date if it is paid in advance, or on 1st January 2004 if it is paid in arrears.
All types of annuity have in common the fact that they provide certainty of income over a given period. They are not usually savings schemes and it is possible that the amounts recovered will be less than the cost of the annuity. This is particularly true for a purchased life annuity. In return for the premium (single or regular), annual payments are made for the duration of the annuitant’s life, however long or short that might be. There are also annuities where the amounts paid depend on the growth of the sum invested, which might be used to buy units.
Where an annuity is payable in arrears, it can either be with proportion or without proportion. This is because each payment is made at the end of the period to which it relates. Thus, when the annuitant dies, there will be a period since the last instalment date for which no payment has been made. Under a with proportion annuity, a proportionate payment will be made to cover this period. This is not the case for a without proportion annuity, where no payment is made.
Temporary Annuity
Some annuities can be bought where the income is paid only for a fixed term, eg. For 5 or 10 years. These are most often used in conjunction with Single Premium Bonds and Endowment/ Unit Linked Savings Plans.
Most temporary annuities are designed to be payable for either a fixed period, or the annuitant’s lifetime, whichever is shorter. If the annuitant survives the fixed period, the annuity ceases, as it does if he dies during that period.
Purchased life annuity
Also known as an immediate annuity, this type of contract provides, in return for a single premium, an annual payment starting immediately and continuing for the rest of the annuitant’s life.
Annuities can be on a single life or joint lives, most usually husband and wife. These policies are particularly popular for retired people who want a guaranteed income for as long as they live. They may be bought with the tax free cash available from a personal pension on retirement.
Where an annuity is being used to provide retirement income for a married couple, it would not be advisable to have a single life annuity, because if the annuitant died first, payments would cease and the surviving spouse would be left with nothing. This has led to joint life last survivor annuities. These contracts pay an annuity for the joint lifetimes of the two annuitants. Payments usually continue in full after the first death, but sometimes reduce by a set amount, say a third.
Deferred annuity
It is possible to establish a purchased life annuity to start paying out at a future date, this being known as a deferred annuity.
The period between the date of the contract and the date the annuity is to commence (often called the vesting date or the maturity date) is the deferred period. Regular sums would be put aside to fund the annuity, often during the deferred period.
If death occurs before the scheduled date for the start of the policy, the premiums are usually repaid, with or without interest. The annuity becomes payable once the vesting date is reached and will continue for the rest of the annuitant’s life.
Certain annuity
An annuity certain is a contract to pay an annuity for a specified period regardless of whether the annuitant survives. It does not depend on the age of the annuitant, as payment is guaranteed for the set period whatever happens.
Guaranteed annuity
For a slightly higher cost than a certain annuity, a guaranteed annuity can be bought. This pays an annuity (to the estate) for a minimum period even if the annuitant dies during that period. If the annuitant lives longer the payments continue.
Thus an annuity guaranteed for ten years will be payable for life or ten years, whichever is the longer. If the annuitant dies during the guaranteed period, then the balance of the guaranteed instalments will be payable to his estate, though a continued cash sum may be payable instead.
Capital protected annuity
For a slightly higher cost than a certain annuity, a guaranteed annuity can be bought. This pays an annuity (to the estate) for a minimum period even if the annuitant dies during that period. If the annuitant lives longer the payments continue.
Thus an annuity guaranteed for ten years will be payable for life or ten years, whichever is the longer. If the annuitant dies during the guaranteed period, then the balance of the guaranteed instalments will be payable to his estate, though a continued cash sum may be payable instead.
Increasing or escalating annuity
Some offices offer increasing annuities, where the instalments increase by a fixed percentage each year. This can help to offset the effects of inflation, although the rate of inflation may well be higher than the fixed rate of increase. You should also remember that a level annuity will be much higher for the same premium than the initial level of an increasing annuity.
A few offices have annuities linked to the Retail Price Index. Unit-linked annuities are also available and three offices have an annuity linked to their with-profits funds. All these types of annuity give a lower initial payment than a fixed annuity, but better protection against future inflation.
Impaired life annuity
In the past, annuities were almost always written at standard rates that did not vary according to the policyholders’ state of health. In a growing number of cases, a person in poor health may be given an enhanced return by certain insurance companies. These are called ‘impaired life annuities’.
Tax treatment of annuities
There is no tax relief for the cost of the annuity. Each receipt from a life annuity is treated partly as a return of the amount paid for it (the capital element) and partly as interest (the income element). Any capital element is tax free but the income element is liable to income tax in full and is usually paid after deduction of basic rate income tax, which can be reclaimed by non taxpayers.
