First off, what is an annuity? An annuity is a fixed sum of money paid to someone each year, for the rest of their life. In other words, it is a form of insurance that entitles the investor to a series of regular payments. So far so good.
Many years ago, interest rates were high and choice was limited. Upon reaching retirement age, it was common for people to purchase an annuity with their pension pot. This provided certainty of income for life, with little to no investment risk.
The main risk is based on your mortality – how long you will live. Heads you win, tails you (and your family) lose.
Yet the appeal of an annuity has waned with the introduction of low interest rates. The number of pension pots used to buy an annuity has reduced to 11% (source: FCA).
These low figures don’t mean that annuity products are dead, and for the right people in the right situation they can be ideal solutions.
What’s the story?
We like to get the most out of our money. Yet these days, finding good value appears to be more difficult. Whether you’re shopping, eating out, or holidaying, your pound doesn’t stretch as far as it used to.
With discussion about global economic instability, it is hard to be optimistic about the future.
The threat of inflation and an uncertain outlook makes careful planning of your finances all the more crucial. Once income from work stops, you are required to depend on what you have been able to save over the years. Your security, comfort, and independence during your retirement depends on how far you can make your assets stretch.
The decisions about where you invest your money for retirement are complex. Nowhere is this more obvious than with annuities. The basic objective with pension investments is to get the best returns possible for what you put in. Yet with annuities, there are several options available which all have their own unique advantages and drawbacks, making it more complex to decide which is the optimal choice for you.
Once you have set up an annuity, it is difficult to change your mind and switch to another, which places a lot of pressure on you to make the right choice the first time around.
If in doubt, nothing beats taking advice from an independent financial adviser.
Annuities as a whole are an important topic, so let’s focus on one type of annuity that gets asked about often - enhanced annuities.
What is an enhanced annuity?
It is easy to understand why people take an interest in enhanced annuities. The ‘enhanced’ part explains the attraction - they pay out at enhanced rates compared to standard annuities.
Enhanced annuities are a type of lifetime annuity and are the most popular form of annuity available, in addition to being more or less the default option. In the most basic terms, lifetime annuities are designed to spread out your finances evenly in order to provide a steady income stream from the point of retirement to death.
But getting something for nothing in life is rare, and enhanced annuities come with a catch. The income paid each month or year is calculated by an insurance company actuary. They know more about health, ageing, and mortality than you, but you know more about your own health than they do.
To get an enhancement you must complete a thorough application, detailing every aspect of your health. Full disclosure - no gaps or omissions.
In practice, pay-outs are calculated according to a life expectancy estimate based on your full medical records.
A less appealing name for an enhanced annuity is an impaired lifetime annuity. This name comes from the notion of an impaired life expectancy, which in turn explains why enhanced annuities pay out more.
An annuity provider may offer you higher regular payments if you suffer from a medical condition which is likely to lower your life expectancy, or on the basis of certain lifestyle factors such as being a smoker or overweight that could do the same. This is on the actuarial assumption that you will live for fewer years than the average person of your age and gender.
Should I buy an enhanced annuity?
There is always a degree of risk involved in purchasing an annuity, especially as you tend to be locked into the product. With enhanced annuities, you are essentially taking a gamble on your life expectancy. If you take the higher pay out but end up living to a ripe old age, you win. If you die early into the contract, the insurance company wins.
You also have to qualify to meet the terms of an enhanced annuity. This in itself can put some people off since many people consider the underwriting application process to be invasive to their privacy. You would have to disclose private details about your health, lifestyle, and your past, while a medical examination may also be required.
Overall, enhanced annuities make most sense for people who have confirmed medical conditions or habits that carry a high risk of shortening or impairing their life expectancy. Examples include:
- Heart disease
- Kidney failure
- High blood pressure
- High cholesterol
- Morbid obesity
Industry statistics suggest that up to 60% of people could qualify for some sort of enhanced annuity rate, yet the take up is only around 20%. This is because, in addition to the above listed conditions, providers will also adjust annuities upwards for things like asthma.
While there is less certainty that these factors could lower your life expectancy, many people see it as worth the gamble to increase their available finances through retirement.
Opting for an annuity at retirement is one of many options open to people. Some retirees like the thought that their essential utility costs are met with a guaranteed income, combining their state pension with an annuity top-up.
Moreover, an annuity may be the only realistic alternative for those with a modest pension pot.
- You can buy an annuity income for life, or for a specific fixed period.
- You can buy an annuity with your own cash if you don’t have a pension pot.
- The annuity can be for your life only (single life).
- Or it could be for your spouse or partner if they survive you (joint life).
- The income you agree to buy with your lump sum can be level throughout, inflation-proofed, or rise at a set rate each year.
- Believe it or not, the postcode ‘lottery’ does exist – where you live may dictate how much you get.
- You can guarantee annuity payments between 5 and 30 years.
- It is possible to capital protect the annuity purchase price. For example, if you spend £300,000 and get £6,000 a year and die at the end of year six, your estate could receive up to £264,000.
The Money Advice Service has a useful online calculator here.
At the time of writing (September 2020), the number of insurance companies offering enhanced/impaired annuities has dwindled to six. But getting the right terms could enhance your regular income by as much as +35%.
A financial adviser can be invaluable when making decisions such as this. Our friendly team includes seasoned professionals with decades of expertise in retirement planning between them.