We suggest you read our Introduction to annuities before you read this section
As an alternative to purchasing a conventional annuity, whereby the pension increases are fixed at the outset, investment linked annuities are also available. Unlike conventional annuities, the level of income is not fixed but linked to the performance of an investment. As long as a set growth rate is achieved, income may be higher than under a conventional annuity and may even increase in the future. However, the income could go down if the required growth rate is not achieved.
Investment (or unit linked) Annuities
Your income in retirement will be linked directly to the value of an underlying fund of investments. Generally, you can choose the types of fund, for example:
The more risky the underlying fund, the more your retirement income may vary – both up and down.
Your starting income is based on an assumed growth rate and if the fund grows at that assumed rate, your income stays the same. If growth exceeds the assumed rate, your income increases. If growth is less than the assumed rate, your income falls. A few unit-linked annuities let you invest in a ‘protected fund’ which limits the fall in your income. Most unit-linked annuities do not guarantee any minimum income. Even if your income is based on an assumed growth rate of 0%, your income could still fall if the value of the underlying investment fund falls.
If the underlying assets are equities, the income payments made are likely to be more volatile compared to a with profits annuity. Although in the long term equities have produced the greatest returns, there is no guarantee that this can continue in the short term.
Tax Free Cash - Tax free cash must be withdrawn at outset then the residual fund is exchanged for a series of payments. Once an annuity has been purchased there is no further entitlement to tax-free cash.
Death Benefits - The option of what type of death benefits to include must be made at outset. The options available are the same as under the Lifetime Annuity.
Unit Linked annuities are most likely to suit individuals who want some guarantee on their pension payments but also want the potential to benefit from future investment return. They therefore suit individuals with low to medium attitudes to risk and security. They also suit individuals who have relatively small pension funds which wouldn't justify Income Drawdown and who will be heavily reliant on their pension income.
With Profits Annuities
A With Profits Annuity provides an income that is linked to the investment returns of an insurance company’s With Profits fund. As for all Investment Linked Annuities, the income payable can go down as well as up in the future. However, With Profit Annuities provide smoothed investment returns, which should mean that in times of falling investment returns, your income will not necessarily go down as much as the underlying investments. It also means that in periods of high returns, not all of the investment return is necessarily paid out as some is retained to cover the bad years.
The With Profits approach is less volatile and has the potential for higher income as the underlying fund will have a less aggressive investment strategy. However, in view of the poor investment returns of the last few years, a limited number of providers now offer With Profit annuities.
This will be the only option – without transferring - for members of their employer’s Defined Benefit (also known as Final Salary) Pension Scheme. Those with other types of pension arrangement can also choose this option if they do not wish to purchase a Lifetime Annuity. These pensions are paid either directly from the original pension scheme or on its behalf by an insurance company.
Payment of scheme pensions from Defined Benefit schemes are guaranteed for life.
Short Term Annuity
A short term annuity will use part of your pension fund to purchase an annuity which provide a guaranteed income for a fixed period of no more than 5 years. The payments must cease before your 75th birthday.
The maximum amount that can be paid is calculated by taking a rate from tables drawn up by the Government Actuaries Department and applying to that part of your fund that is not invested in life annuities.
This maximum amount must be recalculated every five years. The annuity can be level or it can be arranged to increase each year at a fixed rate or in line with the Retail Price Index.
Short-term annuities are intended for those people who do not want to commit their pension funds to a lifetime annuity because they believe the rates may get better in the future. By using a short-term annuity, the decision on buying a lifetime annuity can be deferred but not beyond age 75.
Only part of your fund would be used in this way. The balance would be applied to an income withdrawal arrangement Unsecured Pension, which is explained in more detail later.
Once you have understood as much as you need to about annuities, be sure to use our Retirement Finance Checklist in your run up to retirement.