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!
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: -
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
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.