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Guest post by Mike Campbell -

Today, most people have an occupational pension that they and their employer pay into. This article looks at the product which is bought with this fund when you retire and explains what an annuity is and a little of its long history.

The historical origin of the Annuity

An annuity is a financial vehicle which is intended to provide an investor with a guaranteed annual income. The annuity is purchased with a lump sum and the issuer will then make regular payments to the investor, usually for the rest of their life.

The first widely accepted historical reference to an annuity that can be recognised today can be traced back to the Roman era. However, similar systems in China, Egypt and Babylonia may have pre-dated this by many centuries. Roman society was sufficiently developed, in terms of the understanding of mathematics and statistics that the Romans are credited with the “invention” of the annuity. Roman citizens were able to purchase an “annua” which guaranteed to provide them with a regular income for life, or a specified period, so the basic structure of the vehicle has been in place for thousands of years.

From Roman times, there have been two basic forms of annuity: the first (and the simplest) is to provide an income for the investor whereas the second is intended to provide an income for the heirs of the original investor. The need to disburse the annuity to heirs led to the construction of the first life expectancy table which was attributed to a Roman Jurist, Domitius Ulpianus, during the second century AD.

The first use of an annuity as an occupational pension may have been the provision of soldiers retiring (at 46) from the Legions of Rome. Certainly, evidence exists for the buying and selling of both life- and fixed period- annuities during the Roman period. Authorities could also use the issuance of annuities to fund civic programmes or wars, defraying the payments into the future, so the concept of public sector debt that so bedevils us today is nothing new either.

Modern Annuities

The modern annuity is essentially an insurance product that will make regular payments to the beneficiary until their death. Usually, an annuity is purchased through a pension plan that you (and usually your employer) will contribute to over your working life. Once you retire, the funds available in your pension will be used to buy an annuity which will then provide you with your retirement income.

Obviously, since an annuity may well be your main retirement income, it is important to ensure that you choose the best option from the wide array of choices available in the marketplace to suit your individual circumstances.

As current legislation stands, British citizens who have contributed into a UK pension plan are compelled by the government to purchase an annuity with their pension fund before the age of 75 (although this absolute obligation is set to change in April, providing greater freedom of choice for anybody who can demonstrate that their pension income exceeds £20000). Once the plan has been selected, it cannot be changed, so it is imperative to have good financial advice and to select the annuity best suited to your circumstances.

In the USA, there are two models of retirement plan: defined benefits and defined contribution. In the defined benefit system, an annuity must be purchased upon maturity of the retirement fund and this will provide the defined benefits promised in the scheme. A defined contribution plan has more flexibility in that it can be used to procure a lump sum or to purchase a lifetime annuity or fixed five or ten year plan. It is critical to ensure you understand the options associated with your plan and have a firm indication of the benefits that will be paid to you.

Australian nationals pay their retirement funding into a superannuation scheme which invests their money on world stock exchanges. Upon retirement, Australian citizens have the option of withdrawing a lump sum (so that they could buy an annuity, for instance), obtaining an income stream from the contributions already made, or deferring a decision by leaving the money in the fund indefinitely.

For foreign nationals who have decided to retire overseas, it is important to consider the tax liabilities from the annuity that might arise in both the UK and your adoptive home and ensure that they are minimised.

So, in general, your pension plan provides the “nest egg” with which to buy your annuity. The insurance company which issues the annuity will provide an income to you based on the size of the nest egg that is placed with them but since the annuity rates paid by insurers can vary by 20%, or even more, it is essential to ensure that you select the best choice for your circumstances.

Basic Annuity Choices

There are eight basic annuity models:

1. Single life annuities – these are only payable to the named policy holder and cease upon death of the beneficiary
2. Joint life annuities – are payable to the beneficiary until their death and afterwards are payable to a partner or dependent for the remainder of their life (should they outlive the beneficiary)
3. Level annuities – this policy will pay a fixed sum (monthly) for the rest of the policy holder’s life
4. Index-linked (or escalating) annuities – as the name implies, the income increases by a fixed percentage on an annual basis
5. Impaired life (enhanced rate) annuities – if you have a shorter than usual life expectancy (because of heavy smoking or a genetic predisposition towards heart disease, for instance), it is possible to receive a higher annuity income (often more than 30%) than other policy holders with a longer life expectancy
6. Investment-linked annuities – part of your nest egg remains invested in the financial markets and you draw a fixed income from the rest of the annuity. If the markets prosper, your income will increase in the future, but as the recent global financial crisis has underlined, this is an uncertain proposition since investments can fall as well as rise.
7. Guarantee period – typically, an annuity will guarantee to pay your estate the income that you are entitled to for five years after the policy becomes active should you die during this period. In certain circumstances, this may be extended to ten years.
8. Income Draw-down – this option may be available in some pension plans, but it is not, in itself, an annuity. Rather, it allows some of the money in the plan to be withdrawn whilst the bulk remains invested. It can be an expensive option and still requires funds to be converted to an annuity before the policy holder reaches 75 years of age.

Obviously, the annuity models discussed above have different costs and benefits associated with them, but the list provides a broad indication of the options open to an investor. Normally, the payments are sent to you on a monthly basis, in advance.

If your retirement nest egg is worth £100000 (and the UK national average is closer to £30000) and you retired at 65 taking a single life pension with level payments and a guarantee for five years, your gross annuity would range from £5506 (Axa) to £6778 (Aviva). If the model is changed to give protection to your partner (also 65) giving them rights to 2/3 of your pension after you die, the annuity changes to £4805 (Axa) or £6104 (Aviva).

Opting for an increasing annuity at a fixed level of 3% (to cover inflation), the second set of options would decrease, initially, to give you between £3188 (Axa) and £4253 (Aviva) as a gross annuity. Were you to opt for an index linked system which would protect the purchasing power of your income, the relevant values become £2854 (AEGON Scottish Equitable) or £3583 (Aviva).

From the issuer’s perspective, they must be able to ensure that their return on your initial investment (£100000) is sufficient to cover the annuity and make a profit. This means that they will need to secure a return on investment of between 2.85 and 6.78% per annum to break-even, depending on the option that you selected. By comparison, the US stock market returned an average gain of 18% between 1990 and 1999.

Under UK law, you are not obliged to accept the annuity plan associated with your company’s pension plan under the “open market option” scheme. It makes sense to seek advice well before you retire and may be forced to take a decision.

For expats who are not obliged to purchase an annuity with their pension plan, an annuity represents a mechanism of providing a guaranteed income at a time of your life when earning money may no longer be a desirable option. It provides predictability and security, but is not the only option available to you. As at any time in your investing life, you need to carefully balance the competing demands of risk and return with security.

A Brief Look At QROPS

A QROPS (Qualifying Recognised Overseas Pension Scheme) may be of interest to UK nationals who have contributed to a UK pension scheme but intend to emigrate permanently from the UK in retirement. Since UK pensions are taxable, the advantage of a QROPS is that there is no UK tax liability on the funds in a QROPS, but various conditions apply which are beyond the scope of this article. QROPS are free of a lifetime allowance charge — in the UK; the maximum fund in an individual’s pension is £1.8 million — funds in a QROPS are free from this limitation. They are free from the requirement to use the fund to purchase an annuity (before the age of 75) meaning that the investments can continue to roll-over. QROPS also present tax advantages in leaving lump sums to your heirs. Finally, QROPS pension payments can be made in your local currency, rather than Sterling, so they can provide currency conversion benefits.