Annuities And Their Role in Financial Planning
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Introduction
Annuity rates have risen significantly and, as of March 2023, stand at a 12 year high due to a combination of high inflation, rising interest rates, the war in Ukraine and the fall-out from the Mini Budget.
In this article we will look at some of the rates currently available as well as the features that can be built into an annuity. We will also discuss how annuities can be used as part of a client’s financial plan.
Current Annuity Rates
As an example, we are going to highlight the case of Mr. and Mrs. Mangu. Mr. Mangu has taken his tax free cash and has a pension fund of £1,000,000 with which to buy a Lifetime Annuity using the Open Market Option. Mr. Mangu is 65 and Mrs. Mangu is 62 and both are in good health and are non-smokers.
We have compared the income that could be generated from an annuity that remains level in retirement and one that increases each year in line with inflation.
The joint annuity will be paid monthly in arrears without proportion and include a five year guarantee without overlap and will include a 50% spouse’s pension.
The annuity that remains level generates an income of £61,604 per annum.
The annuity that increases in line with inflation starts at £37,176 per annum.
(Annuity rates as at 19th March 2023 and are subject to change.)
Features of an Annuity
Some of the terms used above probably require some explanation.
Open Market Option
The Open Market Option is where an annuity can be purchased from any provider rather than the provider that holds the pension.
Joint Life
This simply means that we will be including a spouse’s pension and, in the event of Mr. Mangu’s death, 50% of the income will continue to be paid to Mrs. Mangu. It is possible to select an amount of 33%, 50%, 66% or even 100%.
Level
This means that the income will remain the same throughout the life of the annuity. Over time, inflation will erode the real value of the payments.
Escalating
This is where the annuity income increases in value each year and this can be by the rate of inflation, for example, by the Retail Price Index (RPI) or by a fixed rate, for example, 3%.
Frequency of Payments
Payments can be made monthly, quarterly, six-monthly or annually.
In Advance or In Arrears
Irrespective of the frequency chosen, payments can be made in advance i.e. they are paid straightaway or in arrears i.e. after the time period has elapsed. For example, if payments are made monthly in arrears, the first payment will be one month after the annuity has been set up.
With or Without Proportion
Where the annuity payments are to be paid in arrears, if the annuity is ‘without proportion’ the annuity payments will stop immediately on death. If the annuity is ‘with proportion’. The annuity provider will make a pro-rata payment for the period in which death occurs.
Guarantee Period
Including a guarantee period means that the annuity provider will guarantee to pay out the annuity income for a specific period, for example, five years. In this case, if death were to occur after, say, two years, the annuity provider will continue to make payments for the remaining three years.
Overlap
When a guarantee period has been included within the annuity, ‘overlap’ means that both the remaining annuity payments and the spouse’s pension will be paid at the same time. If ‘overlap’ has not been chosen, then the spouse’s pension won’t commence until after the guarantee period has expired.
Value Protection
This will provide a lump sum to the beneficiaries if death occurs and the income received is less than the purchase price of the annuity. The lump sum is the difference between the gross income received and the original purchase price. There will be no lump sum where the income received exceeds the original purchase price. It is possible to select what proportion of the original purchase price to protect.
Impaired Life / Enhanced Annuities
An Impaired Life Annuity will provide a higher level of income where a person suffers from poor health.
An Enhanced Annuity will provide a higher level of income based on factors such as lifestyle (whether you are a heavy smoker), former occupation or even postcode.
Guaranteed Annuity Rates
Many older personal pensions contain guaranteed annuity rates that can be particularly attractive.
Annuities and Financial Planning
Since the credit crisis of 2008, the popularity of annuities has fallen because of ultra-low interest rates and gilt yields. In April 2015, the introduction of Pension Freedoms removed any requirement to purchase an annuity at all. The major drawback for annuities for most people is that if they were to die shortly after purchasing the annuity, the insurance company effectively ‘wins’ and there is little by way of residual monies going to the beneficiaries.
Annuities, however, can still play an important part in financial planning depending on the specific client requirements. An annuity, after all, is a guaranteed income stream.
When we create financial plans we like to break down a client’s expenditure into three main categories; basic, leisure and luxury. For some clients, they like to know that their basic expenditure needs will be met come what may and an annuity can fulfil this requirement. A Flexi-access Drawdown arrangement can then be used to meet the client’s leisure and luxury expenditure requirements.
As clients get older, they might also want to take less risk with their retirement income and may consider annuitising a proportion of their overall pension fund. This may provide additional peace of mind as clients enter later life.
Where clients are in ill-health, it makes sense to consider an Impaired Life Annuity or Enhanced Annuity which could significantly increase the level of income compared to a standard annuity. Increasingly, insurance companies are personalising their annuity underwriting criteria so that more and more people can qualify for an Impaired Life or Enhanced Annuity even based on a few lifestyle factors or conditions such as Type 2 Diabetes.
Annuities as an Asset Class
There continues to be some innovation in this area where providers are looking to essentially unitise their annuity products so that they can be held as part of an overall portfolio. We are watching this space with interest.
Summary
Annuities can play an important role within a client’s overall financial plan offering the peace of mind of a guaranteed income stream particularly during later life. As rates improve they are being viewed as a risk-free option for a portion of a client’s overall pension fund. We are also seeing increasing innovation in this space especially where annuity type products can be held as part of an investment portfolio offering an attractive alternative to, say, Bond investments.
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