Annuity basics

An annuity is a financial policy which converts a lump sum (normally a pension pot) into a series of regular income payments. Annuities have the following features:

• 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 an income or a lump sum can be paid to your family e.g. guarantee period or value protection
• 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

Annuities are unique because they are the only financial policy that guarantees income for life.

Annuities are unique because they are the only financial policy that guarantees income for life. In order to meet the income for life promise, annuities are invested in cautious investments and are based on the concept of mortality cross subsidy.

Insurance companies are able to give the income for life promise, because annuities are based on the concept of mortality cross subsidy. That is, those who die before expected subsidise the incomes of those who live longer than expected.

The amount of annuity income (annuity rate) depends on a number of factors including:

• Age and health – the older the annuitant the higher the annuity payments and if they have certain health conditions they may qualify for a higher (enhanced) annuity
• The annuity options – e.g. single or joint life, level or increasing, income guarantee period or value protection and choice of payment terms.
• Interest rates – annuities are priced with reference to bond yields (fixed interest investments) so when yields are low annuity rates are low and vice versa (see chart)

A good way to explain annuities is to give an example.

Take someone aged 65 using £100,000 to purchase a single life annuity. Using the rates on offer in December 2024 they would get £7,272 per annum before tax for a level annuity. .

If the annuity was inflation-linked they would get £4,807 per annum gross. .

If the annuitant died after say 1 year, their beneficiaries would get income for the next 4 years (5 year guarantee period)..

If it was a joint life annuity (partner aged 60) the annuity would be £6,334 for level and £3,908 for inflation-linked.

If the annuitant died before the partner, the annuity would continue to the partner at 2/3rds of the original amount until they died (joint life 2/rds annuity).

You can see the current rates using my annuity best buy tables.

The short answer is to conatct me and I will get you the best terms for any given annuity option.

I get a daily feed of the latest annuity rates from all the top providers which I use for my best buy tables and to produce my unique annuity charts which are used by many organisations and individuals to monitor annuity trends. I get personalised quotes from a ‘real time’ annuity quotation service which means that I get the very best annuity rates in the market.

If you would like a free and without commitment annuity quotation please contact me and usually I can reply immediately.

I am in the process of setting up my own 'real time' annuity calculator but in the meantime you can use the annuity calculator on the Money Helper website (an arm’s-length body of HM Government) at www.moneyhelper.org.uk

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Annuity options

The highest annuity income is from a single life annuity with no guarantee period. This is because if the annuitant died the day after purchasing the annuity there would be nothing paid to beneficiaries so the annuity company will have made a huge profit (see mortality cross-subsidy).

Understandably, people don’t like the thought that their annuity will disappear if they die soon after handing their money over, so annuity companies offer several different options to provide continued income or a cash lump sum in the event of early death.

These options include:

• Joint life options
• Guaranteed payment periods
• Value protection
• Escalating payments

Joint life options

A single life annuity pays the highest income but stops on death. Those who are married or have a financially dependant partner should consider the joint life option because if they predecease their partner the annuity pension will continue to them at the percentage selected.

The most popular options are 50%, 2/3rds or 100%, however other percentages are available.

Guaranteed payment periods

This can be thought of as insurance against dying sooner after purchasing an annuity. For example, with a 5 year guarantee if the annuitant dies after 3 years, the remaining two years’ of the guarantee period will be paid to beneficiaries.

Most annuities are guaranteed for 5 years by default, but annuity guarantee periods can be up to 20 years.

Value protection

Value protection makes sure the annuitant and their beneficiaries get all the original money back even if they die soon after taking out the annuity. On death, the difference between the annuity purchase price and the amount of annuity payments is paid to beneficiaries.

For example, if the annuity purchase price was £ 100,000 and payments were £ 6,000 per annum but the annuitant died after 10 years, the total payments would be £ 60,000 (£6,000 X 10). If the 100% value protection had been chosen, the remaining £ 40,000 would be paid to beneficiaries.

This sounds attractive, but it reduces the amount of annuity compared to an annuity without value protection.

Escalating payments

An annuity that remains constant throughout the life of the policy is known as a level annuity and pays the highest income.

It is natural to want the highest income initially, but it is important to consider an escalating income to protect the effects of inflation.

Escalating payments can be a fixed amount, e.g. 3 or 5%, or in line with inflation. Some company pension schemes may have a limited price increase, e.g. RPI up to a maximum of 3%.

Payment modes

Most annuities are paid monthly but it is possible to have other payment modes, e.g. quarterly.

Payments can be at the beginning of the period, in advance, or at the end of the period, in arrears.

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.