Annuity Purchase - Pension Annuities Unravelled!

It may help to first of all explain what a pension annuity is. Well quite simply a pension annuity is a guaranteed income payable for life in exchange for the accumulated fund from a pension plan. The pension annuity is normally provided by an insurance company who calculate the amount of annuity based on a number of factors, such as age, gender, life expectancy and current long term gilt rates.

In effect the insurance company is taking a calculated risk that you will live for a pre-determined number of years and you are hoping to outlive their expectancy.

The amount of initial income received will depend on the type of options selected at outset. For instance the highest initial income will be payable on a simple guaranteed single life annuity payable annually in arrears. This figure will reduce with each additional option selected at outset and the amount of reduction will depend on the option selected.

So you can see how important it is to ensure that you select the right options for you, as they will each impact on the initial income received.

The following is a list of the most common options selected in order of cost (by way of a reduction in the initial income).

The least expensive option is the inclusion of a guaranteed period, normally 5 or 10 years. The reason you may wish to include this option is that it guarantees the pension payment for at least 5 or 10 years even if you should die before the guarantee expires.

How regularly you receive your pension will also impact on the initial pension, for instance you can opt for your pension to be paid annually, quarterly or monthly in arrears or in advance. A pension paid monthly in advance will be less than one paid annually in arrears.

Next is the inclusion of a spouse pension if you are married. This can be in the form of a 100% or 50% continuing pension paid to your spouse for his or her lifetime should you die before him or her.

Finally and the most expensive option is the inclusion of index linking to the initial pension, which can be in the form of a link to the Retail Price Index (RPI) or a straightforward fixed rate percentage of say 3% or 5%. This means the initial income will increase each year in line with the chosen indexation for life.

This may appear an attractive option but you need to look at the initial impact on your income and how may years it would take for you to replace that initial reduction.

For example if your initial single life annuity is £10,000 pa including a 10 year guarantee, it will reduce to about  £7,000 pa if you include escalation at say 3% pa. This means that it would take approximately 12 years before you would see any benefit.
I hope this has been of some help in explaining what to some can be very confusing. If you have any comments or questions please let me know.

In my next post I will be looking at some other important pension annuity options, so please tune in.