What is an Annuity? Annuities Explained

Published / Last Updated on 21/09/2023

To explain what an annuity is, the clue is in the title ‘Annuity’ i.e., annual, or yearly.  An annuity in an annual payment amount of income (paid monthly or yearly) to you by an annuity provider having given them your pension fund before or after the tax-free sum lump sum (a Conventional Pension Annuity) or you have paid a lump sum from your savings and investments (a Purchased Life Annuity).

The annuity income payments are either a whole of life annuity (usual for pensions) or a fixed term annuity e.g., 20-year term (usual for purchased life annuities but also available for pension annuities).

Annuity Optional Extras

Just like when you buy a car and pay extra for metallic paint, alloy wheels and a spoiler or pay a higher price for a 2.5L turbo as opposed to a 1.3L basic model, this is the same for annuities.  Optional extras make your annuity more expensive i.e., your starting income will be lower.  Examples of optional extras for annuities:

  • Spouses benefit on early death e.g., 50% of your pension income.
  • Guarantees e.g., a 5-year or 10-year early death guarantee e.g., if you select an annuity with a 10-year guarantee and you die at year 3, the remaining 7 years payments are guaranteed paid to loved ones or your estate.
  • In Arrears or In Advance?  Your annuity income can be paid upfront i.e., ‘in advance’ at the start of the month or period or ‘in arrears’ i.e., it is paid at the end of month or period just like you get paid at the end of the month.
  • With or Without Proportion?  If you die midway through the month or payment period, i.e., you selected the ‘with proportion’ option, your estate will be paid the portion of the annuity due up to date of death.
  • Indexation:  you can opt to have your annuity payments to remain level i.e., never increase (you will get poorer over the years) or increase in line with inflation or fixed rate increases e.g., 3% pa, 5% pa.

Taxation of Annuities

  • Conventional pension annuities are treated as taxable income in full.
  • Purchased life annuities are treated as part return of the original capital you invested (not taxable) and part taxable income.
  • Immediate needs care fees annuity pay not tax when the annuity is paid direct to the care home.

How can the Annuity Company Afford to Guarantee My Income for Life?

The British government (and other governments) need to borrow money all the time to pay for infrastructure projects, high speed rail, new hospitals and schools as well as the pandemic and covid-19 lockdown costs.  They borrow money from pension and investment funds in the form of Gilts (government bonds with the gilt-edged security that it is backed and guaranteed by the government). 

Gilts or government bonds work in the same way as an interest only mortgage.  You borrow money, interest only, and you pay monthly interest payments only with a requirement to pay the original capital borrowed back at the end of the term e.g., in 25 years for an interest only mortgage.  This is the same for gilts/government bonds.  Governments borrow money from your pension fund manager and pay a guaranteed interest rate and then the original capital/loan back at maturity e.g., in 25 years.  This means the annuity company have a guaranteed income by lending yours and others money to the government meaning they can afford to give you a guaranteed annuity for life.  The annuity company then hopes you pass away prematurely, and the capital still loaned to the government is their windfall (unless you have built in some early death guarantees).

Types of Annuities:

  • Whole Life Annuity.
  • Fixed Term Annuity.
  • Investment Linked Annuity that has an investment growth element as well as some conventional annuity to try and secure you ‘pay rises’ in the future if you get some investment fund growth.
  • Enhanced Annuity (if you are a smoker or have other health issues that may shorten life expectancy such as heart problems, cancer, diabetes etc) for pensions or purchased life annuities.  See Enhanced Annuity
  • Immediate Needs Annuity to pay for later life care fees (a special type of enhanced annuity bought by you or your attorneys and paid direct to a care home).  See Care Fees Annuity

Fees for Annuities

We do not take % or commissions on annuities, we charge a fixed fee to make sure you get the highest annuity we can for you rather than your annuity fund being lower because an adviser fee or commission has been deducted.

Instant Fee Quotes in our Annuity Fees Shop: Annuity

Alternative Flexible Retirement

Some people prefer not to lock into an annuity rate for life or a term but prefer to keep control of their pension fund, for it to remain invested and you draw down as much as the pension fund as you want whenever you need it.  This is known as Flexible Drawdown see: Flexible Drawdown

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