By investing your money into an annuity, provided only by insurance companies, you can ensure yourself a fixed income – either now or at a certain point in your life when you think that you'll need it. In return for your lump sum, you receive a payment every month either for the rest of your life or for a fixed term. Most often, people use annuities to guarantee their income in retirement by investing their pension fund or other personal savings.
In fact, until recently, the law stated that any money in a pension fund had to be invested into an annuity when the holder reached the age of 75. This is no now longer the case, but many still choose to use them because of the security they offer compared with open market investments.
Annuities can be useful for plenty more things besides retirement though; be it a lease, an allowance for a relative, to pay education fees or pretty much anything else that requires regular payments.
And there are a whole range of different types on the market to choose from, with some guaranteeing payments with no risk attached and others dependent on economic turns.
How are the payments worked out?
As well as how much you initially invest and the type of annuity you choose, pretty much anything that might affect how long you live could have an influence on what your returns will be. This includes your age, your health, where you live, what you do for work and even whether you're man or a woman, although from late 2012 providers will no longer be able to take gender into account, following a ruling by the European Court of Justice.
A healthy annual return on your investment sits somewhere around the 7% mark, though quotes can differ wildly, with some companies known to have offered rates as high as the 20%. Some providers are prepared to give you better returns if you have a medical condition or a lifestyle choice which heightens the possibility that you'll pass away in the comparatively near future. This could be a terminal illness, a smoking habit or a propensity for extreme sports – it's always worth checking whether there's someone in the market who is willing to take these sorts of things into account.
All payments from annuities are taxable. Ensure you take this into account when calculating what you'll need back from your annuity to support yourself.
What are the options?
A level annuity, sometimes known as a whole life annuity, pays a set amount of money for the rest of the holder's life. If you live longer than you're life expectancy, you'll gain more back than what you put in. If you die before, your returns will fall short of your initial investment. Another concern with this type of annuity is that although you know exactly how much you will get for the rest of your life the payments will not increase in line with inflation – the amount that the things which each of us buy every day go up by each year. Hence, if you live for a long time, you'll be able to buy significantly less with your money as you get older.
There are several other types of annuity which can help you to guard against these problems. With an RPI linked annuity, the regular payments increase directly in line with the retail price index – the official rate of inflation. Alternatively, an escalating annuity pays an increasing amount as the policy matures, with growth rates typically sitting at somewhere in the region of 3% each year. The catch is that the payments will be significantly lower to begin with than they would be with the level option.
With a guaranteed joint life annuity, you can limit the risk that your investment won't make it's money's worth by arranging for your payments to continue to be paid to your survivors if you pass away within a certain period of taking out the policy. You can choose for they payment to be paid as a lump sum or for it continue for either five or ten years and you can choose to cover either 50%, 66% or 100% of your payments. If you live longer than the selected period you will continue to receive your regular payments. Again, though, your fixed income will be diminished accordingly with the length of the payback period you choose and how much is to be paid back. You must choose your period and amount of cover, as well as specifying your benefactor, when you take out the annuity. A single life annuity can also be guaranteed, with the lump sum payment being added to the holder's estate if payable.
If you want to gamble and try maximise your returns, you can opt for an investment backed annuity which are linked to the stock market, with the annuitant choosing a low, medium or high level of risk. As with any open market investment, these could potentially work out to be very lucrative but there is a chance that you could lose all of your money completely. Therefore it is strongly ill advised to take one out if it is to be your only source of income. An alternative, if you are willing to hedge your bets but don't want so much risk, is a with profit annuity, which works by linking your part of your annuity payment to the performance of the holding company and keeping part of it as a level income. This means you can guarantee yourself some level of return and potentially earn more than you would with a straight level annuity if the company does well. By equal measure, your payments could be lower if the company performs poorly.
Are they safe?
Annuities in the UK are regulated by the Financial Services Authority and can only be provided by accredited insurance companies. Furthermore, they are covered by the Financial Services Compensation Scheme. This means that if the provider goes bust, you are guaranteed to get 90 per cent of your money back. Unfortunately, you'll likely lose the other 10% if the company does meets its ultimate demise.
However, in reality, it is very rare event that a major insurance company goes bankrupt. Most financial services firms took a huge knock during the credit crunch but the vast majority weathered the storm, even if it took a government bailout to ensure they did so. Whitehall knows the fallout it would incur if it idly sat back and allowed large amounts of the general public's money to be wiped out.
But the risks presides, nonetheless, however small it is. Luckily, some level of assurance is available and you should certainly seek it. The credit rating company Fitch provides each authorised financial company (as well as governments) with a health rating, on a letter based scale, with the top rating at 'AAA'. Take this as a guide only, though; there were many companies which ran into trouble during the recession despite having the top rating.
Click here to compare pensions from the UK's leading providers on Know Your Money.
Author: KYM Editor
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