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Annuity

In the rush to take advantage of the new pension freedoms it is easy to forget what a pension actually is. A pension is an income paid each month after a person has retired from work. This income continues for the rest of their (and their partner’s) life.

An annuity is the only policy that can pay an income for life because it converts a pension pot into a stream of future income.

What is an annuity

A lifetime annuity is a policy that converts a capital lump sum into a series of future income payments for as long as the policyholder is alive.

Most annuities pay a guaranteed income for life and have the following characteristics:

  • They pay an income for the rest of the policyholder’s life, no matter how long that is
  • They are based on the principle of ‘mortality cross subsidy’
  • Enhanced rates are available for those in poor health
  • On death, payments stop unless a joint life annuity, a guaranteed payment period or value protection option has been selected
  • Payments can remain level or increase each year

Annuities = income for life

The capital from a pension pot (annuities can also be purchased with personal money and these are called purchased life annuities) is used to purchase an annuity from an insurance company who convert the capital into a series of lifetime income payments.

The income for life guarantee is provided by the concept of ‘mortality cross subsidy’. This is where insurance companies make a profit from those dying early and a loss from those living longer, but they use savings from the early deaths to subsidise the income paid to those who live longer than expected. more about mortality cross subsidy

Annuities are a serious thing

Tax

All income payments to the policyholder are taxed as income at their marginal rate. If the policyholder dies before age 75 any income or value protection payments paid to beneficiaries will be tax free. If the policyholder dies after age 75 any income paid to beneficiaries will be taxed at recipient’s marginal rate.

Annuity options

There are many different annuity options such as:

  • Single V Joint
  • Level or escalation

Mortality Cross Subsidy

In order to pay an income for life, annuities can pay are based on the principle of mortality cross subsidy.

This means that those who die before their normal life expectancy subsidise those who live longer than expected.

Read more about mortality cross subsidy (click on graphic)

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If you want to make the most of pension freedoms you should start planning ahead and make sure your financial affairs are in good shape in the years running up to retirement.

William Burrows

William Burrows

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