What is an annuity?

What is an annuity

An annuity is a policy which converts a capital lump sum (e.g. your pension pot) into guaranteed regular (monthly) income payments.

Lifetime annuities pay an income for the rest of your life (and your spouse or partner), no matter how long you live.

There also temporary or fixed-term annuities which only pay income for a set period of time.

Pension Annuities

The most popular annuities by far in the UK are pension annuities and these have the following characteristics:

• They pay an income for the rest of your life, no matter how long that is
• They are the only way of making sure you maximise your lifetime income without taking undue risks
• They are based on the principle of ‘mortality cross subsidy’
• Enhanced rates are available for those in poor health
• When you die income can continue to your spouse or partner
• If you die soon after taking your annuity a lump sum can be paid to your family
• Payments can remain level or increase each year
• You don’t have to arrange your annuity with your current pension provider – you can shop around for the highest paying annuity

Jane Austen wrote “An annuity is a very serious business” in Sense and Sensibility.

Mortality cross subsidy - makes annuities unique?

In order to meet the income for life promise, annuities are based on the concept of mortality cross subsidy.

Actuaries calculate annuity rates assuming people will live until their normal life expectancy but some policyholders will die before they are expected to and some will live longer than expected.

Insurance companies make a profit from those dying early and a loss from those living longer, but they use savings from the early deaths to subsidise the income paid to those who live longer than expected - This is called mortality cross subsidy.

Mortality cross subsidy is unique to annuities and clearly favours those in good health who may live longer than expected at the expense of those who die early.

To overcome this problem insurance companies offer enhanced annuities. Enhanced annuities pay a higher income for those who have a medical condition that may reduce their normal life expectancy (see section on enhanced annuities).

Calculating annuity rates

The person who purchases an annuity is called the annuitant, and the amount of income they receive depends on the following factors:

• The amount of money invested
• Age of policyholder and partner if a joint life annuity
• Anticipated life expectancy (taking health and lifestyle conditions into account)
• The underlying interest rate
• Options selected

See our annuity tables and quick quote calculator to see the current annuity rates

Annuity options

A basic annuity will stop making payments when the policyholder dies. In order to protect against the risk of losing out if the annuitant dies before getting a good return on the investment, or losing out to inflation, annuities have a number of options. These include; joint life, guaranteed income periods, value protection and escalation.

Tax: All income payments to the policyholder are taxed as income at their marginal rate. If the policyholder dies before age 75 any income or value protection payments paid to beneficiaries will be tax free. If the policyholder dies after age 75 any income paid to beneficiaries will be taxed at recipient’s marginal rate

Annuities are very safe – there is no investment risk

In the UK annuity policies are issued by life assurance companies which are regulated by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).

This means that annuities are highly regulated and insurance companies must ensure that they invest their annuity funds in safe funds so they can always meet their future annuity payments. Therefore, annuities are one of the few financial products that provide an income guarantee.

Conventional annuities are known as “non-profit” policies. This means that payments are guaranteed as long as the company is solvent because there is no investment risk. If an insurance company were to be declared insolvent and was unable to pay annuity payments, policyholders are protected by The Financial Services Compensation Scheme (FSCS).

FSCS will compensate annuitants 100% of the total value of the annuity.

Policyholder protection is triggered if an authorised insurer is unable, or likely to be unable, to meet claims against it, for example if it has been placed in provisional liquidation.

However, if you have an investment linked annuity e.g. with-profits, unit linked or flexible annuity, the payments are not guaranteed in the same way.