An annuity can be defined as ‘a type of insurance policy that provides a regular income in exchange for a lump sum.’ (1)
Annuities are most commonly purchased by pension-holders who are coming up to their retirement age. Typically, these people want the safety of a guaranteed fixed income, rather than the uncertainty of continuing to be exposed to the vagaries of the stock market via shares.
At retirement, you will hopefully have built up a large pot of money (capital) via your pension scheme. This pension pot will have largely been accumulated via long-term investment in shares. When you retire, you have the option of taking up to 25% as a lump sum but the remainder must be converted into a pension annuity.
So how exactly does an annuity work? Let’s take an example of a single-payment life annuity. In return for the provision of an up-front lump sum payment, the insurance company guarantees to make a regular series of future payments to the annuity policy holder. These payments generally end upon the death of the policy holder/annuitant. However, it is also possible to set up an annuity so that it will only stop paying upon the death of a second party. So, a husband could set up a joint and survivor annuity that would continue until both he and his wife are dead.
The central benefit of an annuity is the fact that it is a guaranteed fixed income. It will not be effected by movements in the stock market or by general interest rate variances. The fact that it’s a fixed rate helps annuitants to plan their financial futures.
Another benefit depends upon the health of the annuitants. I might retire at 65 and then live until I’m 100. Or I might die when I’m 66. In the former example, I am likely to have derived great value from my annuity, but perhaps not in the latter example! (Note: it is possible to set conditions within an annuity for payments to continue to the annuitant’s estate for a set period of time after their death, but this is likely to mean a smaller income as the trade-off.)
Annuities also typically offer higher returns than standard savings schemes, and there are tax benefits too.
Most of us will at some point need to consider an annuity to help fund our retirement years. When you find yourself in this position, it’s important that you seek advice from a financial planner. It’s also worth noting that annuity rates can vary from provider to provider. So, as with all financial service products, it’s worth shopping around for the best deal. And, finally, it’s worth just summarising again the main benefits of an annuity. It will provide you with a guaranteed fixed income, that will never run out during your life-time, and carries no investment risk. With your annuity in place, you’ll hopefully be able to live a long healthy retirement and get maximum value from the policy!
(1) Annuity definition taken from the Guardian Unlimited website.