Types of Annuity

There are different annuities to suit different needs. The main types are:

• level;

• increasing; and

• investment linked

A level annuity, sometimes called a 'standard' annuity, pays the same income each year for the rest of your life. The main drawback with a level annuity is that what you can buy with the income falls as prices rise through inflation. For example, suppose at the start of your income groceries cost £50 a week. If inflation averages 3% a year for 10 years, their cost would rise to £67 per week. If you could still only afford £50 then you would have to buy fewer groceries. That is the effect of inflation.

Level annuities pay a higher starting income - compared to increasing annuities. Think carefully about the effect of inflation. Could you really cope with having no increases at all in your annuity income during your retirement, which could last 30-40 years?

Harry retires at 55 and, typically, has a good chance of living 25 years or more. After taking his tax-free lump sum he has a fund of £40,000 to buy his annuity. He chooses a level annuity. This pays him around £2,800 per annum (£235 per month or £54 per week).

If inflation averages 3% a year, the buying power of Harry's pension would fall dramatically as retirement progresses. After 10 years his £2,800 annual pension would only buy the same as £2,000. After 20 years it would fall to £1,500, and after 30 years would be £1,100. If inflation averages more than 3% a year then the buying power of Harry's pension will fall even further and faster.

To protect your income from rising prices, you can choose an annuity that is designed to increase each year. There are two main choices:

• escalating annuities - your income is guaranteed to increase at a fixed rate each year, commonly 3% or 5%.
• RPI-linked annuities - your income is adjusted each year to reflect changes in the Retail Prices Index (RPI) - the main measure of inflation used by the government. So, if inflation is 3% one year, then your income goes up 3%. If inflation is 10% next year then your income goes up by 10%. However, your income is not guaranteed to increase each year - if the RPI did not rise, nor would your income. If the RPI fell, so would your income.

With an increasing annuity, the starting income is a lot lower than you would get from a level annuity. For example, for a man aged 65, the starting income from a 5% escalating annuity might be two-thirds or less of the amount from a level annuity. It could take more than 10 years for the escalating income to catch up, and nearly 20 years before the total that you would have received from the escalating annuity exceeded the total from a level annuity.

Hannah retires at age 60. After taking a tax-free lump sum, her remaining pension fund is £35,000. She chooses an RPI-linked annuity. The pension starts at £1,750 a year (£146 a month, or £34 a week). After 10 years, inflation has averaged 2% a year. Her annual pension has increased to £2,133 a year. This means that she can still afford to buy the same as she did with £1,750 10 years ago. Over the next 10 years, inflation averages 10% a year. Hannah's pension increases to £5,533 to maintain its original buying power of 20 years earlier (i.e.£1,750 a year).

Level or increasing?

You need to weigh up whether you think you will live long enough to benefit from the protection against inflation offered by an increasing annuity. Your income requirements may reduce as you become less active in older life - a level annuity may work well for you in a low inflation economy, which we are experiencing just now, but should inflation dramatically increase you may find the purchasing power of your annuity sliding too quickly.

Investment-linked annuities offer the chance of a higher income than you can get from level of increasing annuities (often called 'conventional annuities') linked to fixed interest assets such as gilts and bonds. But you need to be comfortable with linking your income in retirement to the ups and downs of the stockmarket.

Investment-linked annuities are more risky than conventional annuities because:

• your income is likely to change each year, so could go down as well as up.
• the size of any increase is unpredictable

If the risk of an unpredictable and possibly falling retirement income worries you then stick to conventional annuities.

These link your income directly to the performance of the insurance company's with-profits fund. Typically, your income is made up of two parts:

• a minimum starting income - this is usually set at a low level but, unless investment conditions are very bad, you will usually get at least this much income. Some with-profits annuities guarantee it;
• bonuses - The insurance company usually announces bonuses each year. Bonuses can be 'reversionary' (usually announce once a year and guaranteed to pay out for the duration of your annuity) and 'special' - these only pay out a year or so until the next bonus announcement. The amount of any bonus depends on many factors, the most important of which is stockmarket performance. Some insurance company's may guarantee a bonus rate, for example 3% a year. Sometimes you can choose the guaranteed rate, but the higher the guarantee, the lower your starting income.

Usually, your starting income is based on an 'assumed (or anticipated) bonus rate' ABR. You choose the ABR at the outset from a range set by the insurance company - for example 0% (which assumes no bonuses at all) to 5%. Once chosen, most insurance companies do not allow you to change the ABR.

Your choice of ABR may depend on your need for income. For example, suppose you intend to carry on working for now. By choosing a low ABR you can plan for a low income now, increasing by the time you fully retire.

The insurance company announces new bonus rates every year. If the rate equals your chosen ABR then your income does not change. If the declared bonus is higher than the ABR, your income increases. But, if the bonus is lower than the ABR then your income falls.

If you choose a low ABR, your starting income is low. But, you increase the likelihood that future bonuses will exceed the ABR and that your income will rise. You also reduce the risk that your income will fall. If you choose a higher ABR, your starting income will be higher.

If you choose the lowest ABR of 0% - in other words, assuming no bonuses - your starting income will be the minimum. As long as the company declares a bonus, your income will increase. In general, your income cannot fall because the bonus rate can never be lower than 0%. (However, if long term stockmarket performance was very poor, even this minimum starting income could be cut, except in the case of with-profits annuities that guarantee the minimum).

Example of with-profits annuity

Chris is 60 and about to retire. He uses his £100,000 pension fund to buy a with-profits annuity. The starting income depends on the ABR that Chris chooses. His options are:

• The lowest ABR of 0% - Chris' starting income would be £4,600 a year. Providing the insurance company announces any bonus at all, his income would normally increase each year.
• The highest ABR of 5% - Chris' starting income would be much higher at £7,700 a year. His income would increase in future years only if the actual bonus were more than 5%. Every time the insurance company announced a bonus of less than 5%, his income would fall.
• An ABR between 0 and 5% - This gives a starting income of more than £4,600 but less than £7,800 a year.

Unit linked annuities

Your income in retirement will be linked directly to the value of an underlying fund of investments. Generally, you can choose the types of fund, for example:

• medium risk managed fund where the fund manager selects a broad range of different shares and other investments - spreading your money widely reduces risk;
• higher risk fund where a fund manager selects shares and other investments in a particular country - Japan, say - or sector, such as smaller companies or technology companies. Because your money is less widely spread, the risk is higher;
• tracker fund (usually medium risk) which tracks the performance of a particular stockmarket index like the FTSE-100 (top 100 UK companies by market value). Usually, these have lower charges than managed funds.

The more risky the underlying fund you choose, the more your retirement income may vary - both up and down.

Some unit linked annuities work in a similar way to with-profits annuities. Your starting income is based on an assumed growth rate (similar to the assumed bonus rate). If the fund grows at the assumed rate, your income stays the same. If growth exceeds the assumed growth rate, your income increases. If growth is less than the assumed rate, your income falls. A few unit-linked annuities let you invest in a 'protected fund' which limits the fall in your income.

Most unit-linked annuities do not guarantee any minimum income. Even if your income is based on an assumed growth rate of 0%, your income could still fall if the underlying investment fund falls.

You should not consider a unit-linked annuity unless you can cope with an income that can swing widely and may fall. You would need a large pension fund or other sources of income (or both) to fall back on.

Unit-linked annuities are higher risk than either conventional or with-profits annuities.

If you die soon after taking out an annuity, it will not have paid out much. To guard against this, you can choose an annuity with a guarantee period.

These sorts of annuity commonly guarantee to pay out at least five or ten years' worth of income, even if you die within this period. On your death, the income may continue to be paid for the rest of the guarantee period, or it may be paid as a lump sum to your estate (and inheritance tax might be due on it).

If anyone is financially dependent on you, do not look on a guarantee period as a substitute for a joint-life last survivor annuity. If you live to the end of the guarantee period, the survivors will get nothing.

Harriet, 60, retires. After taking a tax-free lump sum, she uses the remaining £30,000 pension fund to buy an annuity. She hopes to live to a ripe old age but, if not and having no closer relatives, she would like to leave something to her nephew. She chooses a level annuity with a ten-year guarantee.

Harriet gets an income of £2,160 a year. Whatever happens the annuity guarantees to pay out 10 x £2,160 = £21,600.

After only two-and-a-half years, Harriet dies. The annuity has paid her a total income of £5,400. The rest of the guaranteed benefit goes into her estate and will be distributed according to her will.

A lump sum can be paid out in the event of death before age 75 but you are also safe in the knowledge that income will be paid out for life, even if that is longer than you had planned for financially.

You can choose to protect up to 100% of the value of your pension fund. Adding value protection will reduce your pension income and you need to be sure that you can still meet your needs.

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Enhanced annuities and impaired life annuities