Purchase Life Annuities
A Purchase Life Annuity (PLA) works in a very similar way to a Lifetime Annuity, in that it provides a guaranteed income for the rest of your life, and various options, including indexation, guarantee periods, spouse’s pensions can included as they can with a traditional Annuity.
There are however two major differences between a PLA and a traditional Lifetime Annuity.
Buying a PLA
Unlike a Lifetime Annuity, which is bought directly from the proceeds of a pension, a PLA is bought with capital which is not held in a pension.
In practice there are therefore generally two sources of money used to buy a PLA; firstly the tax free lump sum from a pension and secondly capital not already tied up in a pension.
When a retiree wishes to maximise their guaranteed retirement income it is common practice, especially if they are a tax payer, to buy a Lifetime Annuity with 75% of the fund and use the 25% tax free lump sum to buy a PLA. This combination of Lifetime Annuity and PLA generally produces a higher net income than if 100% of the pension fund were used to buy a Lifetime Annuity.
Tax efficiency of a PLA
One of the key advantages of a PLA is its tax efficiency, when compared to a Lifetime Annuity.
Payments from a PLA are split into two parts, a capital element and an interest element. The capital element is deemed to be a part return of the original capital used to buy the PLA and as such is not taxable. The capital content varies according to such factors as age, guarantees and frequency of payment.
Only the interest element is taxable and is added to your existing income to determine the rate at which tax is paid.
Purchase Life Annuity rates
Annuity rates are based on a range of factors such as your age, gilt yields at the time of purchase and the options you decide to include in the PLA.
It is also possible to get providers who will offer an enhanced rate, if you suffer from ill health or have lifestyle issues which qualify, for example smoking.
The most common income frequency is monthly, however other options are available, such as quarterly, six monthly or annually.
You also need decide whether your income is paid in advance, at the start of your selected time period, or in arrears, at the end of your selected time period.
Including a guarantee period means that if you die earlier than expected the income from the PLA will continue to be paid for the remainder of the guarantee period.
Guarantee periods generally run for five or 10 years and start from the date you buy the PLA, not the date you die, meaning that if you died two years after buying a PLA with a 10 year guarantee the income would continue to be paid for at least eight years, and potentially longer if you have included a spouse’s pension.
Spouse’s / partner’s pension
A PLA guarantees to pay an income for the rest of your life; however you may have dependents who you would like to benefit after your death, if this is the case you can choose to include a spouse’s pension.
If you are married, in a civil partnership or have other financial dependents you can opt to include an income for these people following your death.
The income paid to your partner, spouse or financial dependent is set by you when you buy the PLA and is typically 50%, two thirds or 100% of your starting income; the higher this level the lower the starting level of income you will enjoy.
Inflation can significantly erode the buying power of a fixed income over a prolonged period of time, indexation can therefore be added to provide a rising income, which should hopefully offset some of the effects of rising prices
Indexation can be included at a fixed annual amount, generally between 1% – 5%, and line with an index such as CPI (Consumer Prices Index) or RPI (Retail Prices Index).
Whilst including indexation will significantly reduce your starting income, by as much as 30% for a 3% annual increase, opting for a level Annuity will leave your income exposed to the effects of inflation in years to come.
Before this decision is made, consideration should be given to the amount of time needed to catch up with the income that would have been paid from a level Annuity. You also need to think about how long it would take to make up the ‘lost’ income from having started at a lower rate.
Including Value Protection means that if you die before the total income payments received are at least equal to the original purchase price, the difference will be returned.
Value Protection and Guaranteed Periods are mutually exclusive. You can have one or the other, but not both.
This lump sum will be tax-free if you die before your 75th birthday. If your death occurs after age 75, a one-off tax charge is then applied by Her Majesty’s Revenue and Customs (HMRC) and is based on the income tax rate of the person receiving the lump sum.
Advantages of a Purchase Life Annuity
- The income produced is guaranteed and not affected by changes to interest rates or stock market volatility
- You can add various options, including indexation, guarantee periods, and spouse’s pensions to mould the Annuity to suit your requirements
- When compared to a Lifetime Annuity, and potentially a deposit account, the tax treatment of a PLA is favourable
- You can make provision for your partner and / or financial dependents
- Various options can be included to ensure that the amount used to buy the PLA is not ‘lost’ if you die sooner than expected
- The risk of you living longer than anticipated is transferred to the insurance company
- If you live longer than anticipated you may get more back in income payments that the cost of buying the PLA
- PLAs are relatively simple plans and do not need annual reviews, which can reduce cost
- For a tax-payer, either at basic or higher rate, a PLA will generally produce a higher net income than the interest received from a savings account
Disadvantages of a Purchase Life Annuity
- The income you receive is partly linked to gilt yields at the time of purchase. If you buy a PLA when yields are low, as they currently are, you may get a lower income than at another time when yields had recovered
- A PLA can never be changed. If your circumstances alter, for example your partner predeceases you, it is possible you could end up paying for an option, in this case a spouse’s pension, which you will never use
- Once you buy a PLA you are locked into that Annuity rate, you will not benefit from improved Annuity rates in later life, which may be generated by worsening health and/or by the nature of becoming older
- If you choose a level Annuity your income will be eroded over time buy the effects of inflation. Conversely if you chose indexation your starting income will be significantly lower
- A PLA could represent poor value for money, with less income paid out than capital used to buy the PLA, if you die early and have not included options such as guarantee periods, value protection and spouse’s pensions
- The more features you choose, such as guaranteed periods, indexation and spouse’s benefit, the lower your starting income will be