This piece first appeared in Reader's Digest in November 2000
The text here may not be identical to the published text
"Psst! Feel lucky? How would you like a sure fire bet? You give me £100,000 and I will give you an income for the rest of your life. Guaranteed"
Tempted? Thousands are. It is a bet on which a whole industry is built. And the bookmaker, sorry, insurance company, wins it more often than not. At 65, a man can expect to live a month short of 19 years. A woman 22 years exactly. So if you live that long the deal is fair(ish!). If you die in five years it is a big win for the insurer. But if you exceed the average life expectancy, maybe reaching 100 and getting that message from the Queen, then you win. Beating the insurance company seems to be a big incentive to live – on average people with an annuity live longer than people without one!
Annuities used to seem a good buy – if you were retired, you could turn say £100,000 redundancy, or savings or pension lump-sum into a good income to boost your pension. But with long-term interest rates falling and life expectancy rising, the amounts paid out have fallen by around 40%. And they can seem a pretty poor return, especially for women. For example, Standard Life, which offers one of the best annuity rates at the moment, would give a 65 year old man £9024 a year for his £100,000. A woman would get less, just £7584 a year. That reduction of £1440 reflects her longer life expectancy. Generally a woman will get between 10% and 20% less than a man of the same age.
The return – 9% for a man and 7.5% for a woman may not seem great compared with an interest rate of up to 7% available on an internet based deposit account. Especially when you consider that, on deposit, you still have the capital at the end. With an annuity, your money dies with you. So you have given up £100,000 (actually your heirs have!) and you get just 2% - or 0.5% for a woman – a year more than you could get if you kept it! And if you do the arithmetic, just giving you back the £100,000 would be £5286 a year for a man and £4545 for a woman. So the actual extra you get from the interest is just £3738 a year for a man and £3039 for a woman. Remember, though, the amount of the investment declines each year as the capital is returned. So over your lifetime you will not have £100,000 invested but, on average, £50,000. Simple arithmetic suggests that the interest rate earned is only 6% for a woman or slightly under 7.5%, for a man. Actually of course the arithmetic is a lot more complicated than that, but it generally does not seem a brilliant deal at all.
An annuity though does has the advantage that it is guaranteed – if interest rates fall further you will still get the £9024 or £7584 a year. And even if you do live to be 100, you will still get the income. There are tax advantages too. If you buy the annuity out of your own money – in other words if it is not part of a pension scheme – there is less tax to pay on the income. The Inland Revenue recognises that most of the money you get from an annuity is just the return of your own capital and so does not tax that part. In this example, just over a third of the annual return is counted as taxable income. The man will pay £668 a year in tax and the woman £554.
However, if the annuity is bought as part of a pension plan, then it is all taxed. That is because the money you put in to a pension plan is tax-free and so the Revenue taxes it when you draw it out. The Chancellor has to have his cut somewhere, but at least he only takes it once! Either way, the taxable income from an annuity counts as investment income and so is taxed at 20% basic rate (and at 40% if your income is high enough to pay the higher rate of income tax).
So far, so simple. But there are lots of choices to make – and lots of scope to get confused and buy the wrong product!
First, do you want any sort of guarantee? Remember the bet you made? Early death you lose, but if you live to get a telegram from the Queen then the insurance company loses? Now, what if you pay out £100,000 and die within two years, having had a measly £15,000 back? Your heirs will not be too pleased. So you can hedge the bet by guaranteeing the income for at least five or ten years. That means that if you die early, your heirs will at least get the income for a fixed period. Of course, this comes at a price. The income is reduced – not by very much if you are 65 when you start the annuity but by quite significant amounts if you are older.
Alternatively, if you are married, you can get an annuity on what is called ‘joint lives’. In other words the income continues while either of you is alive. This is much more expensive. Because it is a bet on the life of a man and a woman, the income you get is even lower than a woman alone would get. An annuity which continues to pay out to the survivor of two people is around a third less than the amount a man would get. And the reduction gets bigger the older you are when you start the deal.
Another big consideration is inflation. It may only be about 3% a year at the moment. But even at that low rate, the value of your fixed annuity income will halve over the 20 years a 65-year-old you can expect to live. At 7% inflation every £1000 will be worth barely £250 in 20 years’ time. And what if you live 40 years? To cover this risk, you can get an annuity that will rise by 5% a year to help cope with, and even beat, inflation. If you take out an annuity at 65, this protection will knock up to a third off your initial income. The older you are when you start the annuity, the less this protection costs because you have fewer years to worry about inflation.
You can boost your income from annuities in two ways. First, make sure the insurer knows all about your bad habits. If you smoke, then you will get a higher income because your life expectancy is less. The higher income continues even if you give up! If you have other diseases you know about, then you may qualify for what is called an ‘impaired life’ annuity. That will pay a higher income to people who have – or have had – illnesses or medical conditions which tend to shorten life. They can include heart problems, cancer, organ failure, stroke, diabetes, bronchitis and a range of other medical problems.
Second, get professional advice and shop around. The difference between the best and the worst annuities can be thousands of pounds a year. And no one company is better or worst overall. Some are better for women, others offer good rates for impaired lives, another group may be better for guaranteed payments over five years, others shine when it comes to inflation-proofing or joint lives. Decide if you want one at all. Get help from an independent financial adviser who specialises in annuities. Check out magazines and websites for comparisons and ‘best-buys’. And above all, get what you want and are happy to pay for, not what someone else wants to sell you. After all an annuity is one financial product that will last you for the rest of your life, guaranteed.