What is a pension annuity?
Pension annuity – what do you need to know?
- Pension Annuities can only be bought with money/funds held within registered pension plans/ schemes.
- The rules governing scheme pensions are generally more restrictive than those for lifetime annuities.
- The annuity income amount payable depends on life expectancy, gilt yields and the options chosen (single or joint life, frequency of payments, overlap, etc.).
What is an annuity?
An annuity is simply a way of providing a regular income. This is most typically to provide an individual with income once they have stopped working.
There are two basic types of annuity: Pension Annuities and Purchased Life Annuities (find out more in our article on Purchased Life Annuities).
How to tell if a pension annuity is a scheme pension or a lifetime annuity
Pension Annuities can only be bought with money/funds held within registered pension plans/ schemes.
In practice pension annuities fall into two types - lifetime annuities and scheme pensions. They are similar in that they provide an income for life but they have different rules. The differences are even more marked following the Taxation of Pensions Act 2014, which introduced Pension Freedoms.
Although historically we use the term "pension annuity" where the rules apply equally to the scheme pension and the lifetime annuity, great care should be taken as scheme pensions do not enjoy much of the flexibility now available (in legislation) for lifetime annuities.
A Scheme Pension is a pension income payable either from the scheme itself or from an insurance company selected by the scheme.
Defined Benefit schemes can only provide pension income via a scheme pension. If the member wishes to access the flexibilities now offered under lifetime annuities they must transfer their benefits prior to crystallisation. However, this action should not be taken lightly, please refer to our article on pension transfers and conversions, including DB to DC transfers .
See Finance Act 2004: s165(1), Pension rules 3
It is possible for a money purchase/defined contribution pension scheme to provide a scheme pension, but a scheme pension may only be paid if the member had an opportunity to select a lifetime annuity instead.
See Finance Act 2004: s165(1), Pension rule 4
Scheme pensions must:
- be paid at least annually, and
- not have a guaranteed period of more than 10 years
- not reduce unless in specified circumstances (changes to income), and
- be paid by the scheme administrator or an insurance company selected by them.
The rules governing scheme pensions are generally more restrictive than those for lifetime annuities.
See Finance Act 2004: Sch 28, Para 2
Lifetime Annuities are payable by an insurance company where the member had the right to choose the insurance company.
The member's right to choose the insurance company is a key difference compared to scheme pensions.
Prior to 6 April 2015 the basic rules applying to a lifetime annuity required that:
- it was paid by an insurance company
- the member could choose the insurance company
- it was payable at least annually and for life
- if it had a minimum guaranteed period, that period was not more than 10 years
- the amount of annuity either could not decrease or could change only in accordance with specific rules set out in regulations
- the potential survivor of a joint life annuity was usually limited to a formal dependant of the member
- it couldn’t create a lump sum on death (other than capital protection)
- it couldn’t be surrendered or assigned, although this was possible through the will, or scheme discretion, for guaranteed periods or to comply with a pensions sharing order. This is also the current situation.
After 6 April 2015, the basic rules applying to a lifetime annuity require that:
- it’s paid by an insurance company
- the member could choose the insurance company
- it is payable at least annually and for life
- if it has a minimum guaranteed period, there is no limit on its duration.
- annuities now have a wider definition of allowed decreases
- the potential survivor of a joint life annuity needn’t be a formal dependant of the member. Previous limitations on the term ‘dependant’, (spouse, civil partner, child under age 23 etc.) no longer apply to lifetime annuities. The annuitant can select anyone to become a joint annuitant. However, this will be subject to acceptance by the provider and may have an impact on the amount of annuity payable.
- In addition to the survivor’s joint life annuity, which can be paid to a dependant or nominee, if there are any unused pension funds available on the death of a member (they could be uncrystallised funds or unused drawdown funds that haven’t been used in the provision of a dependant or nominee annuity) they can be used to provide more death benefits for the dependant or nominee. Where the dependant or nominee designate these death benefits to drawdown and there are funds remaining when they die, these can pass to their successor who can choose a successor’s drawdown, a successor’s annuity or a combination of the two. You can read more about this in our death benefits article.
- A lifetime annuity can’t usually create a lump sum on death (but see Annuity Death Benefits).
- A lifetime annuity can’t be surrendered or assigned, although this is possible through the will, or scheme discretion, for guaranteed periods or to comply with a pensions sharing order. See Finance Act 2004: Sch 28, Para 3 (as amended by the Taxation of Pensions Act 2014)
A section 32 buyout policy will usually provide a lifetime annuity because the member will be able to transfer it to another insurance company to pay the income – i.e. the member can choose the insurance company that ultimately pays the annuity. This assumes that where there is a Guaranteed Minimum Pension (GMP) entitlement, the pension plan has sufficient funds to meet the GMP amount. If the fund is insufficient to provide the GMP, the Section 32 will pay out a scheme pension.
How the law allows annuity income to vary
The law is fairly restrictive on when it allows an amount of scheme pension to change. There is normally no room for variation (unlike with Lifetime Annuities) and the legislation states the circumstances where Scheme Pensions may be reduced or stopped.
There are several situations where a Scheme Pension may be reduced or stopped. These are:
- Where the member recovers from ill-health
- Where all members are affected by a scheme-wide reduction
- Where it’s a bridging pension and the member reaches state pension age
- While the scheme is being wound-up
- Due to forfeiture of entitlement
- On abatement, which applies to public service pension schemes
- When a scheme administrator pays an amount of annual allowance charge
A lifetime annuity may increase or decrease in line with any one or a combination of the following:
- retail prices index/consumer prices index
- the value of 'freely marketable assets' (e.g. shares, OEICs, Unit Trusts, unit-linked pension funds)
- an index of 'freely marketable assets' (e.g. FTSE 100, Dow Jones Industrial Average)
- With-Profits funds
- After allowance for any contractual charges
Conventional lifetime annuities purchased prior to April 2015 are annuities which do not decrease, or any falls are determined by regulations made by the Board of Inland Revenue.
After April 2015, you can still purchase annuities which don’t offer flexible income options, where these are offered by annuity providers. Choosing a non-flexible annuity would mean the Money Purchase Annual Allowance (MPAA) would not be triggered.
However, The Taxation of Pension Act 2014 details changes to new annuities that can be purchased post April 2015. From 6th April 2015, in addition to reductions determined by the Board of Inland Revenue, annuities can decrease by “allowed decreases”, which widens the circumstances in which annuities can reduce.
Notwithstanding the annuity design possibilities of the change in the post April 2015 legislation, detailed above, different annuity contracts may currently use different methods. The following methodology (old rules) will continue for annuities purchased pre April 2015 – this includes a post 6 April 2015 annuity set up as a result of a transfer of an annuity already in payment before 6 April 2015.
- move fully in line with the change in the linked investments/index (Fully Linked - see below)
- vary based on the anticipated growth of the linked investment / index (Investment Linked- see below)
- have maximum and minimum income limits that are reviewed at regular intervals based on the value of the underlying investment / index (Variable - see below)
See Finance Act 2004: Sch 28, Para 3(1)(d) (as amended by the Taxation of Pensions Act 2014)
Finance Act 2005: Sch 10, Para 13(2) and (4)
The Registered Pension Schemes (Prescribed Manner of Determining Amount of Annuities) Regulations 2006 - SI 2006/568
1. Fully Linked
Fully linked annuities operate just as it says. The annuity income will rise and fall based on the increase or decrease in the underlying investment or index. An example is an inflation-linked annuity.
As the name suggests, inflation-linked annuities vary according to the rate of inflation. This is usually the retail prices index (RPI) but could also be the consumer prices index (CPI).
This provides protection against the effects of inflation – an annuity linked to RPI will increase by 3.8% in a year if RPI is 3.8% for that year. The change will usually apply at each one year anniversary of the date the annuity started.
The starting level of an inflation-linked annuity will depend to some extent on the provider's view of future inflation. The initial income amount may start higher or lower than a fixed escalating annuity depending on the rate of fixed escalation chosen. For example, an annuity increasing by 5% pa might have a lower starting income than an inflation-linked annuity, but one with a 2% pa fixed escalation may have a higher starting income.
POINT TO NOTE: the relative difference in the initial income amount of a fixed escalating annuity and an inflation-linked annuity will vary depending on economic outlook/circumstances and may change over time - it is important not to assume one will always start higher than the other.
In a period of deflation (i.e. negative inflation) an inflation-linked annuity may be expected to reduce. For example, if inflation is -2.4% in a year, the annuity would reduce by 2.4%. However, some inflation-linked annuities are written so that they will not reduce even where there is deflation - the annuity will remain at its previous level instead.
POINT TO NOTE: pensioner inflation (inflation for those who are older) tends to be higher than the general measure of RPI or CPI. This means that while an inflation-linked annuity may keep pace with inflation generally that does not mean it will keep pace with inflation for the individual.
2. Investment-Linked Annuities
Investment-linked annuities are those that can alter in accordance with:
- the value of 'freely marketable assets' (e.g. shares, OEICs, Unit Trusts, unit-linked pension funds); or
- an index of 'freely marketable assets' (e.g. FTSE 100, Dow Jones Industrial Average)
- With-Profits funds
- After allowance for any contractual charges
The most common are unit-linked annuities and with-profits annuities.
While investment-linked annuities can, and do, use different underlying investments to determine the amount of annuity payable, they all operate using the same general principles:
- a starting level of income is chosen, usually by the individual from a range set by the annuity provider
- the starting level will equate to a certain rate of growth each year – sometimes referred to as the anticipated growth rate
- the actual rate of growth each year is determined by the growth on the underlying investments chosen - e.g. with-profits fund, unit linked funds
- if the actual rate of growth each year is the same as the anticipated growth rate the annuity will remain level
- if the actual rate of growth each year is lower than the anticipated growth rate the annuity will reduce
- if the actual rate of growth each year is higher than the anticipated growth rate the annuity will increase
POINT TO NOTE: the starting level of an investment-linked annuity will vary depending on the anticipated growth rate (AGR) chosen at the start. For a fund of £100,000 the starting annuity will be higher if an AGR of 6% is chosen as compared to an AGR of 2%. As a general rule, as the chosen AGR gets higher the starting annuity will become closer to the annuity provided through a fixed level annuity. It is usually possible to select an AGR that will provide a starting annuity of the same amount as a fixed level annuity.
The calculation of the annuity moving forward
Current level of annuity x (1 + actual growth rate)
(1 + anticipated growth rate)
For example, for an annuity of £10,000 pa with an anticipated growth rate of 4% pa and an actual growth rate of 6% in the first year, the amount of annuity at the start of year two would be:
£10,000 x 1.06 = £10,192.31
Investment-linked annuities do carry investment risk which neither fixed nor inflation-linked annuities have. This investment risk may help combat the effects of inflation, whilst also providing the opportunity for the individual's money to still be linked with investment performance. The client's income will vary in accordance with investment performance.
POINT TO NOTE: The difference in starting annuity, based on the anticipated growth rate (AGR) chosen, reflects the level of investment risk being taken. The higher the AGR, the higher the investment risk, the greater the chance of the annuity reducing in future, the lower the chance of it increasing in future. A balance has therefore to be struck between the level of risk a client is willing / able to accept, the AGR and the starting level of the annuity.
The difference between the actual and AGR over time can have a significant impact on the client's income, as the following example shows:
- Starting annuity of £10,000
- Assume an AGR rate of 4% per annum
- Assume future growth rates of 2% pa, 4% pa and 6% pa respectively
2% pa growth
4% pa growth
6% pa growth
Annuity to date
Annuity to date
Annuity to date
This helps to demonstrate the nature of the investment risk associated with investment-linked annuities - for those willing to accept the potential variation in income, the difference of the total cumulative income that could be provided from low to high potential investment returns can be huge - more than £80,000 in the above example.
POINT TO NOTE: investment-linked annuities can represent an attractive 'middle ground' in providing retirement income. They provide the opportunity for income to remain linked to investment performance without the annuity rate risk associated with income drawdown. This is particularly the case for those not wanting/needing the flexibility/death benefits that income drawdown offers.
3. Variable Annuities
Variable annuities can also offer an alternative 'middle ground' between conventional (fixed/inflation-linked) annuities and income drawdown.
In a similar manner to investment-linked annuities they offer the ability for a continued link between the annuity income and investment performance.
However, they go one step further than investment-linked annuities in that they can provide wider income limits, have greater income variability and allow for income reviews to be undertaken, all of which are similar in nature to the old rules that were applicable to income drawdown.
Variable annuities are not, however, able to replicate all of the death benefits permitted under income drawdown; in particular, they are not able to return a lump sum on death as income drawdown can.
The income from a variable annuity can be chosen from within a set range which is 50% - 120% of the amount of level annuity the fund could purchase with the variable annuity provider
If the variable annuity provider does not offer level annuities itself the limits will be calculated based on the average of three current market annuity rates for a level annuity. The individual may choose an income at any point between these limits and can vary the amount of income at any time agreed with the annuity provider, as long as it stays within the above limits.
The minimum and maximum income range/limits must themselves be reviewed by the annuity provider at least once every 3 years. That review will set the minimum and maximum for the period until the next review date.
Statutory Instrument – SI 2006/568 The Registered Pension Schemes (Prescribed Manner of Determining Amount of Annuities) Regulations 2006.
POINT TO NOTE: At the outset the fund used to calculate the income limits will be an actual pension fund but at future reviews it will be a notional fund. This is because an annuity contract does not have an actual fund value as such - if it did then it would not qualify as an annuity under tax law. The money has been used at the outset to buy the lifetime annuity but a notional fund value will be maintained and used when calculating the income limits at subsequent reviews.
When the amount of annuity has been chosen the same basic approach to investment returns, as that for investment-linked annuities, can be applied.
The notional fund is linked to underlying investments, such as a with-profits fund or unit-linked funds, and the value of that notional fund will go up or down in line with their investment performance. The annuity is paid from that notional fund and so will also impact its value.
If the value increases, the income limits at a review will also increase, thus increasing the maximum annuity that may be paid.
If the value reduces, the income limits at the next review will also reduce, thus reducing the maximum annuity that may be paid
It is therefore possible for the notional fund under a variable annuity to increase or reduce significantly depending on the level of annuity and investment performance.
POINT TO NOTE: this means that the level of investment risk associated with a variable annuity is higher compared to an investment-linked annuity. With an investment-linked annuity the amount of annuity previously paid out does not have any effect on the possible future annuity, but under a variable annuity it does.
POINT TO NOTE: variable annuities provide a solution to the lack of flexibility in being able to alter income, which is associated with other annuities. They provide a further step toward income drawdown although their inability to offer the same range of death benefits as income drawdown mean they will not be appropriate where death benefits are a key factor.
4. Other Annuity Types
As detailed above, prior to 6 April 2015, conventional annuities could not usually decrease. This limitation will continue to apply to conventional annuities purchased prior to 6th April 2015 (including where such an annuity is transferred to a new provider).
In respect to conventional annuities issued prior to 6 April 2015, they fall into one of two basic varieties:
- those that remain level throughout the time they are paid; or
- those that increase by a fixed amount/rate at set intervals.
A level annuity will pay the same amount throughout the period it is paid.
A fixed increasing (also known as an escalating) annuity will normally increase by a set percentage each year, on a compound basis. For example, an annuity starting out at, say £10,000 per annum might increase by 3% each year, to £10,300 in year 2, to £10,609 in year 3 and so on.
POINT TO NOTE: a level annuity will generally provide the highest starting amount of income as compared to most other annuities (variable annuities being a notable exception). This is because if increasing annuity options are incorporated, the cost of providing those must be met and that is managed by reducing the starting level of annuity income. So, an increasing annuity will have a lower, possibly much lower, starting income than a level annuity.
The risk of the amount of a conventional annuity reducing is very low - that would only potentially happen if the provider paying the annuity became insolvent. Even in that scenario the protection afforded by the Financial Services Compensation Scheme is 100% of the claim, with no upper limit.
POINT TO NOTE: This credit risk applies to all annuities, not just fixed annuities.
The inflation risk associated with conventional annuities (and level annuities in particular) should not be overlooked. Level annuities can often be seen as carrying no risk but the gradual loss over time of the buying power of the annuity is a risk that should always be borne in mind. This is particularly true the longer the period over which the annuity is expected to be paid.
Inflation erodes the purchasing power of money over time - £100 in today's money will buy you less than £100 in, say, 5 years' time because of the effects of inflation on the cost of living.
So an annuity that is level will lose its value over time, where inflation is positive.
An increasing annuity provides some protection against this, although the level of that protection depends on the difference between the rate of fixed increases and the rate of inflation -– if the rate of inflation is higher than the rate of escalation, the purchasing power of annuity income will reduce in value over time and vice versa.
Protected Rights Annuities
Annuities paid from 'protected rights' pension funds were previously subject to some specific legislation.
- the annuity must be calculated based on unisex rates (i.e. the annuity rate used must be the same for a man and woman of the same age)
- if the member is married the annuity must include a survivor's annuity
- where a guaranteed period is included it cannot be more than 5 years.
The Personal and Occupational Pension Schemes (Protected Rights) Regulations 1996, SI 1996/1537
Historically there were greater restrictions on protected rights annuities, but these were reduced gradually over time. Protected Rights were abolished from April 2012, at which time the above restrictions also disappeared. On retirement, there are no longer any legal restrictions regarding the form of protected rights annuities and so all of the other options described above are available.
Protected rights annuities already set up will continue to operate on the basis they were set up.
Enhanced and Impaired Life Annuities
Enhanced Annuities are annuities that provide higher income amounts than a 'normal' annuity because of the individual having a lower than 'normal' life expectancy.
This reduced life expectancy could be due to long-standing lifestyle or health issues. For example, smokers, those with high blood pressure or relating to the specific health of the individual.
Enhanced annuities usually operate on the basis of a standard, higher, annuity rate being applied. For example, a smoker may get a set annuity rate, which is higher than for a non-smoker. There is no assessment of the individual's health as the enhanced rate is a 'standard' enhancement to the ordinary annuity rate.
Impaired life annuities are, however, specific to the individual. They involve an underwriting assessment of the individual in order to assess his or her life expectancy, based on his or her own health. A higher annuity rate might then be offered as a result of that assessment.
POINT TO NOTE: the terms 'enhanced' and 'impaired life' have tended to become mixed over time. The introduction of 'post code pricing' has not helped as these could potentially be regarded as 'enhanced' annuities. The terms are, perhaps, irrelevant, though as the most important point is could the individual get a higher annuity income because of his/her health.
Factors influencing the annuity amount
There are 3 main factors affecting the amount of annuity income payable from the annuity purchase price:
1. Life expectancy
This is linked to age, health and, until 1st December 2012, gender.
Annuities are a guarantee of an income for life, therefore the rates they're based on change as life expectancy increases. The younger people are when they retire, the longer they are likely to have in retirement and the longer the annuity is likely to be payable. For this reason, a 60 year old will generally receive a lower income than a 70 year old, if buying a lifetime annuity on the same date.
If the prospective annuitant, or one or both joint life annuitants or the dependant of an annuitant has a medical or lifestyle condition they may qualify for an increased income through ‘enhanced’ terms. This normally pays a higher income.
Until 21 December 2012 annuity rates could be based on gender. Generally, females received less income as they lived for longer. Since then annuity rates must be on a gender neutral basis by law.
2. Gilt Yields
Gilts are government bonds. The government issues gilts to raise money - in return they pay an amount of interest. In conventional Gilts this amount is fixed for the lifetime of the bond and is known as the coupon. For example, the government may issue Treasury 5% 2026.
This shows who issued the Gilt (Treasury), the interest rate to be paid (relative to the initial price) and when it is due to be repaid.
This means it has a coupon rate of 5% based on the initial nominal value of £100. £5 per annum will be paid out to the holder of the gilt until 2026 when the government will repay the £100 - a 5% yield.
After being issued by the Debt Management Office in the first instance, Gilts can then be traded on the secondary market where the demand for and supply of them will determine their value. If demand increases then prices rise so yields fall and vice versa. This means a good day for bond holders will see the asking price of their bonds go up but their running yield fall. Therefore a fall in bond yields is not necessarily bad news and may be good news depending on your objective.
In the example above, if demand caused prices to rise to £150 then the yield would fall to 3.33% (£5/£150). However, if the Gilt is held to maturity the government will repay the original £100 not the current market price (in this case, £150).
As well as those conventional Gilts discussed above there are index-linked gilts, double-dated gilts and undated gilts. Of these the index-linked is most common making up around 30% of the Gilt market. There are very few double-dated and undated Gilts remaining.
Annuity providers predominately buy gilts to match their annuity liabilities. Therefore, movement in yields will impact the annuity rates offered. Lower yields = lower rates and vice versa
3. Options chosen
There are many options available with annuities. They can be:
- single life or joint life (post 6th April 2015 the joint annuitant, subject to the provider's approval, may be anyone selected by the annuitant. The selected age etc. of the joint annuitant may have a significant impact on the initial annuity income, for example if the annuitant selects a grandchild as a joint annuitant, the initial annuity will be considerably lower than if the joint annuitant was of a similar age to the member).
- guaranteed or not guaranteed (previous 10 year limit no longer applies to new annuities purchased post 6th April 2015)
- escalating or not escalating
- frequency of payments
- whether payment is in advance or in arrears
- with or without overlap
The more options added the lower the income will be. Likewise, the type of option taken has an impact. For example, a 15 year guaranteed annuity will pay less initial annuity than a 5 year guaranteed annuity and a joint life annuity where there is no reduction on death would pay less than one with a 50% reduction on death. (Please note that for annuities arranged after 6th April 2015 there is no limit on the guaranteed period that can be built into a Lifetime Annuity, subject to being offered by provider).
All things being equal:
Highest annuity payment
Lowest annuity payment
paid in arrears
guaranteed (the longer the guarantee, the lower the starting annuity)
escalating by RPI*
paid in advance
*The actual cost of the escalation would depend on the escalation amount. RPI escalation is not necessarily the most expensive.
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Purchased life annuities: the facts
See how purchased life annuities provide a guaranteed income normally until death or expiry of a fixed term.
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Death benefits and annuities
Learn about the death benefits that can be provided if a member purchases an annuity contract, and the resulting taxes payable.
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Taxation of pension income
We outline how pension income is taxed as earned income, using Pay As You Earn (PAYE) and cover some key considerations. Usually the income is initially set up with an ‘emergency tax code’.