Principle of Annuity Income
A normal life insurance policy involves the payment of regular premiums by the policyholder in return for a final cash benefit on maturity or death. The annuity simply reverses this situation, in that the life insurance company guarantees, in return for a lump-sum payment, to pay a regular income to the annuitant until his or her death. On taking out an annuity, the annuitant therefore loses control of the capital invested.
The principle of annuities is simple enough, and even the British Government issued them until as recently as 1992. From the mortality tables the company's actuary knows the average proportion of people of a given age who will die each year, and from this, together with the rate of interest obtainable on investments, the annual sum that can be paid to each annuitant can be worked out. Some annuitants will die early, soon after paying their lump sum, and the office will make a "profit"; some will live for more or less the average period the actuary has estimated and receive all the capital back that they originally paid over (plus interest); while others still will live to a very ripe old age and the office will make a "loss". Of course, as with life insurance proper, the different experience of all individuals is encompassed within the mortality statistics. While in ordinary life insurance "the burdens of the few are borne by the many", in annuities almost the opposite is the case, for it is the losses of the few (the minority who die soon after taking out their annuities) that provide for the propensity of many annuitants to live longer than the average.
The investments in which the company invests its annuity fund are often Government securities or other fixed interest investments such as local authority loans. The reason these are normally chosen is that they enable the company to obtain the highest possible secure income on its annuitants' money and also to match the income to the expected periods for which it is to be paid.
Annuities used to be a favoured investment for retired people who had saved up money throughout their working life and wanted to obtain an income from it higher than that available from deposits or stock market or other risky investments. The return from the annuity is higher because of two factors: first, each annual payment consists of an element of both interest and capital, and, secondly, the yield from the underlying investments (long-dated gilts) is usually the highest income safely obtainable on any investment. Only the interest portion of each annual payment is taxable, so that the net annual return from an annuity will far exceed that obtainable, say, on equities.
However, the steady increase in inflation since 1990 has had a very severe impact on those who purchased annuities on retirement at the start of that decade. The fixed annual payment of annuitants has been eroded in spending-power terms and in some cases hardship has resulted. The dangers of contracting for a fixed income in inflationary times should not be forgotten when considering an annuity, but it may still provide the best net return when compared with other types of investment.There are several different types of annuity matched to particular needs which are considered below.
An important option that is available under all self-employed pension plans is to take part of the benefits as a tax-free cash sum at retirement. The amount taken can be up to three times the remaining annual pension - a complicated sum to work out but one usually provided in companies' illustrations. The policyholder can take a smaller sum of cash if he wishes.
It will normally be worth the policyholder's while to take the biggest possible tax-free sum at retirement. The reason is that any pension payable under the pension plan will be taxed as earned income, while if cash is taken and... see: The tax-free cash sum