Richard Alexander looks at the ins and outs of annuities

WHILE I always recommend a cautious approach to annuities they can be the right solution for those seeking a guaranteed income, either on a temporary or permanent basis.

Annuities are often considered in relation to pension funds but they are also available to buy direct.

What is an annuity and how does it work? The annuity is an investment contract of sorts and is typically available from insurance companies or specialist providers. In exchange for a capital sum, they guarantee to provide an income on whatever basis is agreed with them. This could be for a fixed term or for your lifetime.

It may provide a level income, or it may escalate at a fixed rate or in line with inflation, and it could just be for one person or be on a joint life basis.

The main benefit is that the income is guaranteed, regardless of changes in the financial markets. The strength of the guarantee is therefore reliant on the annuity provider being able to meet those guarantees.

The way that they do this is to invest heavily in long term gilts, effectively “backing up” the annuity guarantees. This is why long term gilt yields will have an influence over the rates of annuity that are available.

The annuity provider is in business to make a profit, after all, and if they have agreed to provide an income for your lifetime they will do their sums, a bit like a bookmaker, to determine their risk and to add a margin for profit. This effectively means they are assessing how long the annuitant will live and on average they expect to “win”.

They “win” when more people live for a shorter period than expected than live for a longer period than expected. The actuary determines a projected lifespan, and one of the reasons annuity rates have fallen so far over the past 20 years is that people are generally living much longer.

This fact, coupled with the financial world changing so drastically over the same period is why the income level from these contracts is so much lower than it once was.

Having said that, 2013 has seen a reversal in the downward trend, with long term gilt yields increasing steadily, and consequently annuity rates have been increasing too; some long term rates are up as much as 9% this year.

However, as we know, markets are fickle and tend to be cyclical in nature; what goes up has a habit of coming down again. This could well be the case with annuity rates, because we are seeing a slow down in the long term gilt yields and some commentators are predicting that the “bull run” for them is just about over.

If this is the case and an annuity is the right contract for you, then perhaps, now is indeed the right time to buy.

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