Types of Annuity

When you are choosing an annuity (see Annuities), it is important to consider the different types of annuity on offer and assess which one might best suit your needs. Insurance companies offer a range of annuities depending on your personal circumstances and your financial needs. It is sensible to consider the advantages and disadvantages of each annuity on offer, as well as compare the annuities with one another to determine which option best suits your current situation and your financial expectations for the future.

• Level annuity – this annuity remains constant for as long as you continue to receive it (until your death). You will be offered an annual pension on the basis of your age, health, the size of your pension fund and the economic conditions of the time. Unfortunately if inflation continues to rise, your annuity will have less buying power in the future. If inflation rises sharply, you may find that your annuity will buy you very little.
  
  
• Escalating annuity – this annuity increases each year by an agreed percentage, protecting the value of your annuity somewhat against inflation. If your annuity is increased by 3% a year and inflation rises at only 2% a year, your money will have the same or better buying power than before. If inflation increases by a greater percentage than your annuity your money may have less buying power but will still be protected against inflation significantly better than if you had opted for a level annuity. Because your annuity will increase each year, you will begin with a lower annuity than you would be paid with a level annuity.
  
  
• RPI Linked annuity – this annuity increases in line with the Retail Prices Index, which reflects the annual increase in the cost of buying goods. An annuity which increases with the RPI will retain its buying power, that is to say, you will be able to buy the same amount in the future as you can now with your annuity. This financial security will however result in a smaller annuity than you would have been offered had you opted for an annuity which pays you the same amount each year. Essentially this is because your annuity will cost the insurance company more money in the long term. If your annuity is RPI linked and the RPI increases by five percent each year, in ten years your initial annuity of £1000 will cost the insurance company £500 more; therefore the amount they offer you initially will be reduced.
  
  
• LPI annuity – an LPI annuity, or Limited Price Indexation annuity, increases your annual pension in line with the RPI, but only up to a limit, or 'cap' in the form of an agreed percentage. This means that your annuity is treated in much the same way as an escalating annuity; you are protected somewhat against inflation because your annuity will increase each year. However, with an escalating annuity your annual pension will be increased by a certain amount each year, say three percent. An LPI annuity will increase in line with the RPI up to an agreed percentage: if your LPI annuity has a cap of 3% and the RPI increases by 2.5%, your annuity will be increased by 2.5%. This is not too detrimental because your money retains its buying power. If the RPI increases by 6% however, your annuity will be increased by a maximum of 3% and so you lose some of the buying power of your annuity. You will also be offered a lower annuity than you would have been given if you decided on an annuity which pays the same amount each year.
  
  
• Joint annuity – a joint annuity will pay you an agreed annuity until your death. However, after your death the insurance company will continue to pay your annuity to your surviving partner until they die. This type of annuity allows you to ensure that your loved ones will be financially secure after your death. However, depending on your life expectancy and the life expectancy of your partner, the annuity you are offered will usually be smaller than a traditional annuity, because the insurance company will pay the annuity for a longer period of time.
  
  
• Guaranteed annuity – a guaranteed annuity will pay you an annual pension for an agreed period of time, say fifteen years. If you die during this period of time, your annuity will continue to be paid to a surviving relative or friend. This option allows you to ensure that your survivors will be provided for in the event of your death, and makes sense if you are reasonably certain you will die within a certain period of time. The annuity you are offered may be lower than a traditional annuity would pay, because the insurance company will have to pay the annuity after your death for a guaranteed number of years.

• Protected annuity – if you choose a protected annuity, your annuity will be paid until your death, whereupon any remaining pension fund will be taxed and paid to your surviving relatives. If you purchase an annuity of £4000 for a pension fund of £60,000 and die after three years, your insurance company will pay your relatives the value of your pension fund minus the pension that has already been paid out. The remaining amount is subject to tax at thirty-five percent. Your relatives would receive:
  
                     ((£60,000 - (£4,000 x 3)) / 100) x 65 = £31,200

• Impaired Life annuity – if you have reason to believe that your life expectancy is impaired, it may be worth considering an impaired life annuity. Impaired life annuities take your poor health, perhaps due to weight problems, alcoholism or a debilitating disease, into consideration. As a result of your current state of health or unhealthy lifestyle, you may be offered a higher annuity than usual because you are not expected to live many years longer.
  
  
• Investment-Linked annuity – an investment-linked annuity bases your annual pension income on the stock market, which means that the value of your annuity is uncertain. You stand the chance to receive more than you would have done from a traditional annuity if your investments make good returns, and risk losing out if your investments do badly. It may be a good idea to choose this type of annuity if you have a pension fund you are willing to risk, perhaps because you have other sources of income and would receive only a small annuity from an insurance company. An investment-linked annuity is not usually a wise choice for anyone who has limited financial security.
  
  
• Short-Term annuity – a short term annuity offers you a traditional, level annuity for a set period. Instead of choosing a level annuity until you die, a short-term annuity gives you an annual pension for a number of years and then stops. When your short-term annuity comes to an end, you are free to choose another short-term annuity or purchase a different type of annuity. You can continue to purchase short-term annuities until age seventy-five, when you will have to purchase a long-term annuity. A short-term annuity may be a good choice if the current economic climate has resulted in low annuity rates and you believe your fund will buy you more in a few years.

The different types of annuity are directly compared below:

When choosing an annuity it is imperative that you spend time researching your options and calculating your best deal. Without investigating a range of options at a range of insurance companies, you can be sure you are not ensuring you find the best deal for your future financial security. Ask an independent financial advisor to assess your options and advise you on the annuity best suited to your needs.

For more details on annuities see Calculating your annuity and Deferring your annuity purchase. With financial peace of mind you can face a happier retirement.