Annuity - What is it?

An annuity is a policy which converts a capital lump sum (e.g. your pension pot) into guaranteed regular (monthly) income payments.

An annuity is a financial policy which converts a lump sum (normally a pension pot) into a series of regular income payments.

Lifetime annuities pay an income for the rest of your life (and your spouse or partner), no matter how long you live. There also temporary or fixed-term annuities which only pay income for a set period of time.

Annuities have the following characteristics:

• Income payments are guaranteed for life or a fixed term
• They can be a single life or a joint life policy
• Income payments can be guaranteed for a minimum period of time
• It’s possible to have a ‘money back’ guarantee called value protection
• Income can remain level or increase by a fixed percentage, or in line with inflation
• Enhanced annuities are available for those who are overweight, smoke, take qualifying prescription medication, or have a serious illness.
• Annuities can be purchased using pensions (pension annuities) or from personal savings (purchased life annuities)
• Pension income is taxable whereas purchased life annuities are mainly tax-free

Annuities are unique because they are the only financial policy that guarantees income for life. In order to meet the income for life promise, annuities are invested in cautious investments and are based on the concept of mortality cross subsidy.

Insurance companies are able to give the income for life promise, because annuities are based on the concept of mortality cross subsidy. That is, those who die before expected subsidise the incomes of those who live longer than expected (see box).