Short Explanation of a With-Profits Annuity

by Peter

These link your income directly to the performance of the insurance company’s with-profits fund. Typically, your income is made up of two parts:
a minimum starting income – this is usually set at a low level but, unless investment conditions are very bad, you will usually get at least this much income. Some with-profits annuities guarantee it;
bonuses – The insurance company usually announces bonuses each year. Bonuses can be ‘reversionary’ (usually announce once a year and guaranteed to pay out for the duration of your annuity) and ‘special’ – these only pay out a year or so until the next bonus announcement. The amount of any bonus depends on many factors, the most important of which is stockmarket performance. Some insurance company’s may guarantee a bonus rate, for example 3% a year. Sometimes you can choose the guaranteed rate, but the higher the guarantee, the lower your starting income.
Usually, your starting income is based on an ‘assumed (or anticipated) bonus rate’ ABR. You choose the ABR at the outset from a range set by the insurance company – for example 0% (which assumes no bonuses at all) to 5%. Once chosen, most insurance companies do not allow you to change the ABR.
Your choice of ABR may depend on your need for income. For example, suppose you intend to carry on working for now. By choosing a low ABR you can plan for a low income now, increasing by the time you fully retire.
The insurance company announces new bonus rates every year. If the rate equals your chosen ABR then your income does not change. If the declared bonus is higher than the ABR, your income increases. But, if the bonus is lower than the ABR then your income falls.
If you choose a low ABR, your starting income is low. But, you increase the likelihood that future bonuses will exceed the ABR and that your income will rise. You also reduce the risk that your income will fall. If you choose a higher ABR, your starting income will be higher.
If you choose the lowest ABR of 0% – in other words, assuming no bonuses – your starting income will be the minimum. As long as the company declares a bonus, your income will increase. In general, your income cannot fall because the bonus rate can never be lower than 0%. (However, if long term stockmarket performance was very poor, even this minimum starting income could be cut, except in the case of with-profits annuities that guarantee the minimum).

Calculator PencilA with-profits annuity is an annuity that will tie your annual income into the performance of your pension provider’s with-profits funds. Your retirement income is based on your starting income and bonuses that are paid out annually. These will have lower starting incomes compared to level or conventional annuities. However the lower starting income means there is money available to be invested in the with-profits fund. As mentioned, an additional annual payout is made based on the bonus percentage paid by the fund (which itself is determined by the overall performance).  You choose what is known as an Anticipated Bonus Rate (ABR) at the start of the policy. This can be anywhere between 0% and 5%. A zero percentage ABR assumes there will be no bonus at all so any bonus declared will see your income increase.

Should you opt for a low ABR then your starting income will be lower but you can plan for a higher income in the future as the fund has less of a percentage increase to achieve for you to get a higher income. You can also protect yourself against a drop in income as the fund as further to fall behind for you to get a lower annual income.  If you opt for a higher ABR your starting income is higher  but you can only increase your income if the fund performs very well and pays a bonus above your ABR. As with most options in annuities, it’s horses for courses…if you have the luxury of being able to take a higher risk you could earn a higher reward. Some policies have built in bonus levels so check with with an annuity specialist to see what option is best for you.

Advantages

By using the Anticipated Bonus Rate (ABR) a With Profits Annuity offers you a much greater level of flexibility compared to a Inflation Proof Annuity or even a Conventional Annuity. You will get higher increases in income in the future when the ABR is lower. You will know that with a With Profits Annuity your income will never fall below a certain amount. In the long run your income could even grow faster than inflation, although this would entirely depend upon the relevant funds’ performance, inflation levels and the ABR rate each year.

Disadvantages

With a With profits annuity your income could indeed increase but there is also the danger that it could decrease to a level lower than what you had in the beginning. (although this doesn’t apply to Protected Rights benefits – these cannot fall to a lower level than at the start) Of course with this type of pension annuity there is no guarantee of a rising level of income. There is also little point looking at what has been in the past or what is on the horizon as circumstances can change quickly. If you have other sources of income at retirement and can take the relative risk then this maybe the option to maximise your potential retirement income.

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