Annuities

If you need a regular income for the rest of your life you could purchase an annuity. In exchange for capital an insurance company will guarantee a monthly income for life. An annuity is exactly like a capital repayment mortgage where you are the lender and the institution pays you the monthly repayment.  The term of the “mortgage” is to the date of death.  This is in practise your life expectancy. Take the following example.

An insurance company will first estimate your life expectancy (or joint life expectancy for couples). For the sake of a simple example, assume this is only ten years. If you had £20,000 to invest, the company would be able to return one tenth of your capital back to you each year. That’s £2,000 per annum.

In addition, interest of say £600 pa on average is also payable. So your total income would be £2,600 per annum (13% pa), of which £2,000 is called the capital element (and is tax free) and £600 is the income element and subject to tax. The actual figures depend on your particular age and life expectancy, and the income is usually paid monthly in advance.

If you should live longer than the ten years in this example, the insurance company will still continue to pay you the £2,600 per annum until your death. On the other hand if you died earlier the annuity ceases. Since an insurance company deals with a large number of people it can offset the ‘loss’ it suffers from a longer-than-average life with the ‘profit’ obtained from shorter lives. But if you and your partner died earlier than expected, neither of you are in a position to worry about it!

Income Tax
You will have probably already spotted in this example the comparison with a capital repayment mortgage.  A £20,000 mortgage over ten years at 6% interest would also cost about £2,600 per annum, payable monthly, the same as used in the example above.  But with such a mortgage the mix of capital and interest varies each month with more interest to start with.

Fortunately the revenue only taxes the income element of a purchased annuity – the capital element is tax-free since it is a return of your own money.  But they take a simple approach and assume that the interest and capital element is constant throughout.  The capital element is roughly equal to the initial investment divided by the life expectancy.  This is good news, since the levelled interest element is less than it should be to start with so the income tax is lower than is should be to start with – but higher later on.

This taxation treatment differs from Pension annuities (called compulsory purchased annuities) where the whole annuity income is taxed, but then the initial investment was tax deductible at the time.  This is why it is usually worth while taking the maximum tax free lump sum from a pension, even if it is invested right back into a purchased annuity, because the tax treatment for purchased annuities is more favourable than for compulsory purchased annuities.

What age should you buy?
The older you are, the higher the income you receive from an annuity, but the less time you have to spend it. So a younger age does not necessarily mean poorer value for money, although a fixed, lifetime income may be eroded by inflation.

Varieties of Annuity
There are various types of annuities.  For example: -

• Guaranteed.  In exchange for a lower income, you can guarantee a minimum payment period regardless of death during that period – typically 5 or 10 years. They will of course continue to pay income until death regardless of your actual life span.

• Capital Protected. I n exchange for a lower income, on death the insurance company will return your initial capital less any gross payments already made.

• Joint.  Joint life annuities provide an income until the last survivor dies. Obviously the income will be lower as joint life expectancy is longer than for a single life. But there are various combinations. For example, a pre-agreed reduction in income on the first death will increase the initial income.

• Increasing.  You can choose an income that increases by a preset amount each year or even by inflation. The initial income is lower to start with.
  
• Equity-Linked.  Instead of a guaranteed income, you can opt for your annuity to be linked to the performance of an equity or property fund such as an insurance company’s with-profit fund.

Mathematically, all varieties of annuities are near enough identical value for money.  They operate much like a repayment mortgage over a pre-set lifespan.  The IRR is much the same for almost any combination when you take life expectancy into account.  Bearing in mind the insurance company take the risk of you living longer, the deal can be a good one.

Some people just do not like the idea of “losing their capital".  This is an inaccurate view, since the capital is not actually lost – it is paid back over a period.  As I mentioned earlier, if you died earlier than expected, before the capital element was all paid back, you couldn’t have taken it with you anyway.  Better for you to have the guarantee of a lifetime income regardless of how long you live in exchange.

Many people feel than annuities currently offer a bad deal.  But this is due to two things:  interest rates have fallen and life expectancy has increased.  This does not affect the basic principle of an annuity which is a safe income augmented by withdrawing capital, but without risk of actually running out of capital.  Imagine any alternative investment that produces such a high, safe income.  The equity-linked variety would suit a more adventurous investor, at least in part.