The purchase of an annuity may be one of the most important financial transactions in your life. If it is a compulsory annuity, it's important to get the best rate and the right type to suit your circumstances.
"Voluntary" annuities are a different breed, especially as far as tax is concerned and the question arises as to whether it is the right long-term decision for the individual.
Defined-contribution pension scheme members and holders of personal pension plans need to understand how annuities work and the various options available. Following the 1999 Finance Act, the self-employed and propriety directors have additional options open to them and may be able to choose not to buy an annuity.
An annuity is the payment of a regular income from a life company to an annuitant in exchange for a lump sum, either for life or for shorter periods. At retirement, one option is to take up to a maximum of 25 per cent of the accumulated fund as a tax-free lump sum. The balance can be used to purchase an annuity or, subject to certain conditions, can be transferred to an approved retirement fund.
When the time comes to purchase a compulsory annuity, most pension arrangements allow an "open market" option. This means the individual or trustees can purchase an annuity from any insurance company in the market, regardless of where the pension fund was invested.
Usually an annuity ceases with the death of the holder but it can be designed to be paid to a surviving spouse at a reduced rate up to two-thirds of the original rate.
The idea of someone's entire pension fund disappearing on their death soon after retirement has put some people off annuities. But no other investment route can match the security annuities provide for people who live out their life expectancy and beyond.
Whether an annuity ceases to be paid when the annuitant dies depends on the terms chosen by the purchaser. It is possible to buy a single-life annuity that is simply paid for your own lifetime.
It is also possible, and may only impact slightly on the regular payment, to incorporate a minimum guaranteed period of payment, usually five years. Mr John McGovern of Becketts Employee Benefits Consultants recommends that the guaranteed period is put in place.
Mr McGovern also advises clients to consider inflation proofing the annuity. You can buy an annuity that is payable as a level amount throughout your lifetime or an escalating one that increases during payment at a fixed percentage, typically 3 per cent.
If you are a member of a defined-contribution scheme, you will generally have a choice as to what features are incorporated in your annuity contract. If you are buying an annuity from a personal pension plan, you are left to your own devices and should seek professional advice.
A voluntary annuity bought with your own money is called a purchased life annuity. According to Mr Owen Morton of Moneywise Financial Planning, these are not popular because they entail relinquishing control and ownership of hard-earned money. Legacy considerations can also come into play. However, where there is a requirement to squeeze a maximum income stream from a limited capital resource, an annuity is hard to beat.
Mr Morton cites an example of an individual aged 75 with £100,000 (€127,000). A purchased life annuity will yield a flat life income, guaranteed in any event for five years, of £12,000 per annum. This type of annuity enjoys preferential tax treatment, with £9,700 regarded as a return of capital and exempt from tax, and £2,300 classified as interest and taxed at source under PAYE. Income stream from compulsory annuities, where money is emerging from a pension fund, is fully taxable under PAYE. In circumstances of modest existing income, it is unlikely that any tax liability would arise.
For those who can choose, there is no simple answer to the question - is an annuity the right route to take? If you live for many years after buying the annuity, the payments will represent good value. Anyone purchasing an annuity today will receive payment based on current interest rates for life. If interest rates were to rise in the short to medium term, today's annuitant might feel they had received poor value.
The Pensions Board advises that if your main priority is to ensure some of the capital passes to your spouse or children on your death, an annuity would not be the best way to achieve this. This is an area that calls for expert advice. Intermediaries charge an average of 2 per cent commission to arrange annuities, although it should be possible to negotiate the commission or arrange the purchase for a flat fee.
A company coming out on top for one type of annuity or age may not be so attractive for a different set of benefits or a different age and it is therefore imperative to shop around before making a final decision.
Non-profit annuity: This is the most common type of annuity. It guarantees the future instalments and is not subject to any fluctuation because of investment conditions in the future.
With-profit annuities: This guarantees a lower minimum payment than a non-profit annuity. However, it is increased by the addition of bonuses that are designed to reflect investment returns being earned by the insurance company as the annuity is being paid.
There is some risk to the annuitant as bonuses will not be guaranteed.
Unit-linked annuities: These give payments expressed as a fixed number of units in a fund being paid out every month. This produces a variable pension because the value of the units may go up as well as down, depending on the investments in the fund.
There is a risk that the fund value could fall.
Impaired-life annuity: If an individual is not in normal health for a person of their age, some insurance companies may offer a better annuity rate.
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