Annuities

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Pensions guide » Individual Pensions » Annuities » Types of annuities

Different types of annuity

Annuities are not all the same. They vary in terms of how they are taxed, how they increase year on year, whether anything is payable to a spouse and whether they contain any sort of guarantees. The options are described below in more detail.

The taxation of annuities

There are essentially two types of annuity in terms of how they are taxed. Compulsory Purchase Annuity (CPA) - These are the annuities which you must buy with the proceeds from your Personal Pension, occupational DC scheme or AVCs. The income from CPAs is treated as earned income and will therefore be taxed just like any other piece of income. The money used to purchase CPAs has come from your pension pot. The money in your pension pot was not taxed when you earned it as contributions to pension schemes are free from income tax. Therefore the government taxes the income at retirement to avoid missing out altogether. In this sense the government does not give you the tax on the contributions it just lends it to you until you retirement and then it taxes the income then. Purchased Life Annuity (PLA) - These annuities are not purchased with the proceeds from pension funds. Therefore you can any money you hold in the bank (or anywhere else for that matter outside of a pension fund) and go and buy a PLA if you wish. As these annuities are purchased from income which has already been taxed not all of the income they provide is taxed. An element of each payment is instead deemed to be a return of your original capital and this element is not taxed. As an example assuming a 65 year old buys a PLA of £8,000 per year for a sum of £100,000 and that the insurer expects this person to live 20 years. Each payment of £8,000 would be assumed to contain (£100,000 / 20) £5,000 of capital. Therefore only the excess over this return of capital (in this example the excess is £8,000 - £5,000 = £3,000) would be treated as earned income and subject to income tax. The £5,000 would be free from income tax.

Annuity Options

So far we have talked about buying 'an annuity'. However there are a few different options when buying an annuity. It is best to seek financial advice when purchasing an annuity as rates can vary significantly between insurers and the rate secured when you retire can have a significant influence on your level of income in retirement.

Increases to annuities

Annuities can be purchased which either stay level over the term of their payment or which increase year on year. Annuities which increase year on year are understandably more expensive than flat annuities although they provide some (or total) protection against increases in the cost of living, i.e. inflation. Flat (Non-increasing) - Flat (or non-increasing) annuities do not increase. However that said these are generally the most popular type of annuity purchased from Personal Pensions. It may be because flat annuities have the highest level of initial income. However they provide absolutely no protection against inflation and could led to high level of poverty in old age. Even in a relatively low inflation environment where inflation averages 2.5% over the course of 10 years the buying power of a flat annuity would have reduced by 22% and after 25 years it will have reduced by around 50%. If inflation averages 5% over the next 25 years the buying power would be reduced by a whopping 70%! Index Linked (Linked to RPI) - Index linked annuities rise year on year by the change in the RPI. However as said earlier these annuities are much more expensive that flat annuities (a typical annuity might be 30%-40% more expensive than a flat annuity). As a result the initial income from an index linked annuity may look very low compared to that from a flat annuity. The annuity would fully protect the holder from high price inflation. Fixed Increases (3%, 5%) - Annuities are also available that provide a fixed level of increase year on year of typically 3% or 5%. These annuities provide some protection against inflation if inflation averages around these levels but provides no protection if inflation rises unexpectedly. With profits - It is also possible to purchase what are known as with profits annuities. A with profit annuity will not guarantee a particular level of increase but will instead grant annual bonuses dependent upon the performance of the life insurers investments in their with profits fund. If you seeking to purchase any of these sorts of annuities please seek financial advice beforehand so that you fully appreciate the risks taken and obtain the best rates in the market.

Joint Life Annuities (JLA)

It is also common for individuals to want to provide for their spouse in the event of their death. This can be achieved by purchasing a joint life annuity. It is common for this annuity to provide a specified level of income whilst both lives are alive but to have this reduced to 50% (or 2/3rds) when one of the lives involved dies. Therefore a JLA could be used to provide a pension of say £12,000 to a husband and wife whilst they are both alive and then have this reduce to £8,000 (2/3rds) once either of the husband or wife dies. Other possibilities also exist whereby the level of pension stays at 100%. This would effectively mean that the pension was payable until both lives were dead.

Guarantee Periods

Many people are concerned about dying very early on in their annuity contracts and losing the substantial sum of money that have just passed to the life insurer. To alleviate this concern it is possible to purchase annuities with a 'guarantee period'. Common periods are 5 and 10 years. If you purchase a guarantee period option then if you die within the guarantee period the life insurer will pay out the remaining payments due to the end of the guarantee period as a lump sum. Therefore if you purchase an annuity (with a 5 year guarantee) of £10,000 per year and die after exactly one year the life insurer will payout a sum of 4 * £10,000 = £40,000. Where 4 is the number of years to the end of the guarantee period.