Lifetime Annuity Option and Additional Bolt Ons Explained

What is a lifetime annuity?

You keep your existing pension funds with your current pension company and then elect to either take your tax free lump sum (usually 25%) or not from your pension fund with the balance remaining being the taxable part of your pension fund.  The pension fund is retained or used by your pension company to buy an annuity.  Your pension company arranges this and then gives you a monthly or yearly guaranteed income known as an annuity based upon your age, life expectancy and other factors.  The annuity will then pay you a regular income, usually for life, hence it being known as an Lifetime Annuity.

It is also sometimes known as a conventional annuity.

How is it calculated?

Based upon your age, health, smoker status, life expectancy and other options such as level pension, increasing pension income, death benefits, spousal benefits and guarantees, the annuity rate will be set.  The annuity rate is usually linked to gilt yields.  Gilts are basically loans to the British government for a guaranteed income plus capital return at maturity.  In short, your pension company ‘lends’ your pension fund to the government and the government then pays your pension company interest (usual fixed rates but there are index linked gilts too).  This is how the pension company can afford to give you a guaranteed annuity income for life as it has a guaranteed income from gilts.

Choices with a lifetime annuity:

Your pension company will normally ask what annuity options you require.  Each additional ‘bolt on’ is like buying a car i.e.  the more accessories you have the more expensive the car (or the annuity) is as follows:

Level or increasing annuity?

The simplest and cheapest annuity is the level annuity.  This means it will pay out the highest income but you will gradually get poorer over the years as inflation/living costs rise.  Annuity companies will offer you the choice to start income at a lower point but then options for the income to increase each year either by a fixed % e.g.  2.5%pa, 5% pa or by inflation.  Inflation linked annuities are the most expensive (i.e.  the starting pension income will be the lowest) as they increase by an unknown amount for the rest of your life so the annuity company has an unknown liability but it is inflation protected income.

Single life i.e.  an annuity income in your name only or joint lives with legally married spouse or civil partner?

For joint lives annuities, the starting payment will be lower and it is paid to you and on your death it will continue to be paid to your spouse at either 100% of the original income or at lower amount to your partner e.g.  75%, 2/3rds or 50%.

With Guarantees?

Your pension annuity income is guaranteed for life.  If you die prematurely, there is no value in your annuity, the pension fund value is gone.  This is unless you have built in a spouses benefit for income to continue.  In addition, you can also usually opt for a 5 year or 10 year guarantee.  This means that if you died let’s say 3 years after starting your annuity, for a 5 year guarantee the pension company would pay out a further 2 years pension income to your estate as a lump sum or with a 10 year guarantee with death after 3 years, a further 7 years pension income would be paid to your estate.

In Arrears or In Advance?

Thing of this like your pay when you start a job.  Most people usually work a week or a month in hand before you get paid.  This is the same for your pension annuity, monthly in arrears i.e.  you get your income at the end of the month.  You can elect for your annuity to be paid in advance i.e.  your receive your first annuity income payment on day 1 (this is the ‘ever so’ slightly more expensive option).

With Proportion or Without Proportion?

If you decide on a monthly in arrears annuity.  If you pass away half way through the month, you will not receive the half month’s pension payment due unless you elect for ‘with proportion’ – again this is the slightly more expensive option.

Examples:  You telephone your pension company for an annuity quote:

1. You may say “I would like a single life, no spouse, level payments, no guarantees, monthly in arrears, without proportion annuity quote please” – this would be the cheapest option i.e.  the biggest starting income payment level.
2. Or “I would like a joint lives, 50% spouses, payments increasing with inflation, 10 year guarantee, monthly in advance, with proportion annuity quote please” - this would be a much more expensive option i.e.  one of the lowest starting annuity income payments (roughly half that of option A above).  Having inflation protection is the most expensive benefit that can be built into a pension.

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