Annuities can be valuable for many people by turning their pension savings into retirement income. Yet annuities take many different forms - each one tailored to a specific purpose.
This can be confusing for those browsing different annuity products.Below, our Chartered Financial Planners explain the main annuity types to know about in 2023 and how they can be used in a retirement plan.
What unites all annuities together?
Before delving into the differences between annuities it helps to know what their common traits are. In general, annuities are a type of financial product which provide a regular income in retirement.
Annuities can be purchased using an individual’s pension savings. For instance, at age 55, someone might choose to take 25% of their pension as a tax-free lump sum. Half of the remaining amount is kept invested. The rest is used to buy an annuity.
Annuities are typically sold by insurance companies and cannot be returned after purchase. So, it is wise to explore all of your retirement income options with a financial adviser before committing to one. This minimises the chances of buyer’s remorse later.
How long do you want your annuity income to last? With a lifetime annuity, it will continue indefinitely until your death. If you want long-term security and stability, reducing the risk of running out of money in retirement, this can be an attractive choice.
There is no investment risk with a lifetime annuity. Once purchased, the insurance company which sold you the product will be responsible for ensuring your continuing income.
If your provider ever goes bankrupt, the insolvency practitioner would first try to find an alternative insurer to take on the liabilities. Otherwise, your annuity would be covered by the Financial Services Compensation Scheme (FSCS).
Many annuities also offer a “value protected” option. This directs your provider to pay a lump sum to your loved ones for the amount you protected - minus any income payments already made.
The opposite, in a sense, to lifetime annuities, a fixed-term annuity will pay an income for a specific period of time - usually between 1 to 40 years. 5 or 10 years is more common.
At the end of the fixed-term period, the annuity provider pays out a lump sum (“maturity sum”) which you can use as you please, such as buying another annuity.
The maturity sum is agreed upon at the outset of buying a fixed-term annuity. Generally, you can choose to receive a lower income for a larger maturity sum at the end, or vice versa.
One advantage of a fixed-term annuity is that it does not lock you in forlife. There is more in-built flexibility and you could potentially take out a new annuity when the deal expires, - possibly when rates have improved.
For instance, perhaps you want an annuity to provide a “bridge income” between now and when you start taking your state pension in a few years. If so, a fixed-term option could work.
Do you want your annuity to provide the same level of income each year? A level annuity may be for you.
Often, level annuities paya higher level of starting income compared to other product types (e.g. rising annuities). However, you face the risk that the real value of your income will fall over time due to inflation.
For instance, suppose inflation rises by 2% each year over the next ten years. By year ten, your annuity income will be worth more than 20% less than at the beginning. Even though the income is the same, the spending power falls.
A level annuity can be suitable if you have other assets or income sources that can offset the risk of rising inflation, like your state pension.
This is an umbrella term describing various annuities which offer a rising future income. An “escalating” annuity, for instance, will increase your income by an agreed amount each year (e.g. 3%).
By contrast, an “index-linked” or “inflation-linked” annuity will adjust your income periodically based on a specific measure such as the Consumer Price Index (CPI). If inflation goes up by 4% for a while, therefore, your income should also rise by 4% at the next adjustment.
Another annuity type which might fall into this category is a “variable” annuity. Here, the income will change in value based on the performance of its underlying investment portfolio. These are more common in the USA, but they are now gaining more popularity here in the UK.
Each of these options carries distinct pros and cons. An escalating annuity will help to protect the value of your income against rising living costs. However, if inflation rises past your agreed escalating rate, then you may still lose income value in real terms.
An inflation-linked annuity is perhaps the best protection for retaining your spending power against rising living costs. However, these products are often more expensive than other annuities. Moreover, if the UK ever entered a deflation period, these annuities might even see their incomes reduced.
A variable annuity can offer higher returns if the underlying investments perform well. However, the income could fall if the investments underperform. Moreover, most variable annuities will charge fees which can eat into your returns.
For those who have been diagnosed with an illness or with health problems, an enhanced annuity (or “impaired life” annuity) can offer a higher income than other annuity options.
Here, the annuity rate is highly dependent on your life expectancy (using yourmedical information). They can be more tailored to your unique health and circumstances, possibly adding extra benefits such as death benefits for your spouse.
However, enhanced annuities are more limited in availability and may require the disclosure of more detailed information about a person’s medical history and conditions, which some people may find invasive or uncomfortable.