Income for life - guaranteed

An annuity in the UK financial services sector has a particular life form quite different from virtually anywhere else in the world. For example, a fixed annuity in the United States is a mutual (unitised) fund that produces a fixed-rate annual return. Hence, in the 1990s, when guarantee riders that are optional from fund to fund were added to the fixed annuities, the term "variable annuity" was coined.

In the UK, quite simply an annuity is a contract that pays a specified income - the annuity - each year that the annuitant lives or for a particular number of years that the person on whose life the arrangement depends lives. In the pension arena, these are now called a lifetime annuity (LTA) or a temporary annuity, available between the ages of 50 and 75.

The LTA is a secured pension and the temporary annuity falls in the unsecured pension arena. For the purposes of this discussion, I shall concentrate on the various forms and uses of an LTA.

The big pro

The major advantage of an LTA is that the income is guaranteed by life. Currently, annuity rates are at a six-month high, and these arrangements represent good value for money. However, the perception is the contrary since 10 years ago general interest rates were around 7.5%, but now stand at around 5%. The pension annuity rate has moved in a similar manner meaning that today's LTA rates, while the best since January 2008 are still only two thirds of what they were 10 years ago.

Add to this accelerating longevity, and quite clearly, the LTA is excellent value for money. For an example of this see table below.

Even using the conservative Interim Life Tables from the Office of National Statistics, the conventional LTA offers excellent value for money. At each of the ages surveyed below, the male average life expectancy exceeds the period over which the pension capital is returned as gross income by a significant period.

What are the cons?

This has to be that the LTA, once purchased, cannot be altered from the basis purchased at outset. A single-life, level LTA cannot be changed to joint-life should the annuitant subsequently become married or enter into a civil partnership. Similarly, a joint-life arrangement remains joint-life even if the dependent annuitant predeceases the main annuitant. Also, the onset of illness or disability does not allow the LTA to be renegotiated on an enhanced basis.

Conventional LTA

This is the basic pension arrangement. The main differences, post-simplification, are that the compulsory purchase annuity could not be transferred on an individual basis, and it was not possible to return any unused fund to an individual annuitant's estate on death.

Since simplification, it has been permitted to transfer the individual annuity liability to another provider, however, the HMRC Registered Pension Schemes Manual states that "There is no obligation requiring an insurance company to either make or accept a transfer of a lifetime annuity liability. It is not something the member can instigate without the agreement of the insurance company concerned." Furthermore, "there would also need to be agreement between the two insurance companies on the value of the annuity business in question based on an analysis of the policy terms and conditions."

On the question of some form of 'return of fund' similar to an income drawdown contract, it is now possible, i.e. "Where a member becomes entitled to a (...) lifetime annuity contract is purchased on their behalf the arising pension entitlement may be granted pension protection. This means that the (...) insurance company guarantees that they will pay the balance as a lump sum death benefit if:

- The member dies before their 75th birthday, and

- The member has not received a certain total level of scheme pension or lifetime annuity payment by that time.

This is known as an annuity protection lump sum death benefit." In other words, the LTA purchase price minus the gross income taken - at which point a 35% tax charge is taken - with the net amount paid to a beneficiary or the deceased member's estate. In the case of a joint life arrangement, the main annuitant must die before they are 75, however this lump sum payment is made only on the survivor's death at whatever age death occurs. The lump sum payment has all gross income payments made deducted from the original purchase price with the residue subject to 35% tax at source.

Enhanced/lifestyle/impaired life LTAs

These are traditional LTAs able to offer special annuity rates. They are split into the following sections:

Enhanced: special rates often combining an enhanced rate for smokers and/or poor health;

Lifestyle: special rates due to lifestyle choices potentially including smoking, excessive drinking to the degree that life would be shortened, and morbid obesity;

Impaired life: special rates where there are health problems not just that people 'live with', but where the prognosis is exceptionally poor, e.g. advanced or inoperable cancers.

To put it bluntly, the provider is saying that they expect the applicant's life to be shorter than normal, therefore the annuity yield can be greater than normal.

With-profits/unit-linked/flexible LTAs

A with-profits LTA is backed by a with-profits fund where an assumed bonus rate (ABR) between 0% and say 5% is set at outset, and the annuity payable from year-to-year is that 'reversionary' bonus rate, and is an assumed percentage of the with-profits fund applied to your annuity.

Obviously, if your ABR is set at 5% but the actual bonus rate is 2.5%, the fund subsidises your pension, and the reverse is true; 2.5% ABR with an actual bonus rate of 5% declared on the fund enhances your individual with-profits fund. A 0% ABR equals a 'true income', i.e. you are paid the declared rate as an annual income.

Unit-linked LTAs operated in a similar way to the with-profits version. Your fund was invested in a unit-linked managed fund with a pre-determined number of units cancelled each year to provide income. The onset of greater investment volatility following the golden 1980s made the income from this arrangement quite unpredictable.

Flexible lifetime annuities must be reviewed at least every five years, and the income is reset for the next five years at each review. A desirable aspect of these contracts is that the income that can be taken is between 50% of the provider's conventional LTA rate and 120% of the same. Furthermore, a joint-life annuity can be altered to a single-life version at any review, and subsequently revert to a joint-life basis. At each review, the annuitant may transfer to a conventional or enhanced LTA if desired.

These products are not to be confused with the new wave of so-called "variable annuity" as these latter products sit squarely in the unsecured pensions/alternatively secured pensions segment as guaranteed income drawdown products.