An annuity (sometimes referred to as an immediate annuity) is a low risk investment made to an insurance company with the value of your pension fund when you retire.
The annuity company will pay you an income for the rest of your life, however long that may be. When they work out how much to pay you, they take into account factors like your age, lifestyle, health and post code. The ability to pay an income for life comes from the use of cross subsidy where those who die before their capital has been repaid in full subsidise those who live past the point at which they have withdrawn more that the annuity purchase price.
The type of annuity that is purchased at retirement is commonly referred to as a compulsory purchase annuity. Under current UK legislation funds accumulated from a pension where the investor has received tax relief on their contributions, must be used to buy an immediate annuity.
Alternatively these funds can be used to purchase a form of unsecured pension income (commonly referred to as income drawdown) where the purchase of an annuity is delayed Where the purchase of an annuity is delayed the retiree risks what is referred to as mortality drag whereby income taken diminishes the amount that can be used to buy an annuity. If an annuity is purchased, the income is taxable.
Retirees have the option of taking 25% from their accumulated pension funds as a tax free lump sum or Pension Commencement Lump Sum.
The 25% that can be withdrawn as tax free cash can be used to buy a Purchased Life Annuity (Link to Jargon Buster) which is a voluntary purchase made by the investors own free will. As such the income from a purchased life annuity is split in the eyes of HMRC into return of capital and interest.
Return of capital is not taxed and since this makes up the bulk of the income payable, this makes income from Purchased Life Annuities much more beneficial to retirees who expect to be tax payers into retirement.
The annuity itself is low risk as the main underlying investment the annuity companies use to provide the income is Government Bonds (GILTs) which are loans to the Government and other high grade bonds. While these types of investments are perceived to be low risk, when compared to other forms of investing, for example stocks and shares, they will pay a yield which is driven by market forces.
Yields are very low at present due to the economic climate and this is reducing the income payable from immediate annuities. Also see How safe is my annuity?
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