Investment Linked Annuities

The chance of a higher income in the future - but only by taking extra risk.

Investment-linked annuities offer the chance of a higher income than you can get from level of increasing annuities (often called 'conventional annuities') linked to fixed interest assets such as gilts and bonds. But you need to be comfortable with linking your income in retirement to the ups and downs of the stockmarket.

Investment-linked annuities are more risky than conventional annuities because:

• your income is likely to change each year, so could go down as well as up.

• the size of any increase is unpredictable

If the risk of an unpredictable and possibly falling retirement income worries you then stick to conventional annuities.

• 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).

• The lowest ABR of 0%

  Chris' starting income would be £4,600 a year. Providing the insurance company announces any bonus at all, his income would normally increase each year.

• The highest ABR of 5%

  Chris' starting income would be much higher at £7,700 a year. His income would increase in future years only if the actual bonus were more than 5%. Every time the insurance company announced a bonus of less than 5%, his income would fall.

• An ABR between 0 and 5%

   This gives a starting income of more than £4,600 but less than £7,800 a year.

Unit linked annuities Your income in retirement will be linked directly to the value of an underlying fund of investments. Generally, you can choose the types of fund, for example:

• medium risk managed fundwhere

  the fund manager selects a broad range of different shares and other investments - spreading your money widely reduces risk;

• higher risk fund

  where a fund manager selects shares and other investments in a particular country - Japan, say - or sector, such as smaller companies or technology companies. Because your money is less widely spread, the risk is higher;

• tracker fund

  (usually medium risk) which tracks the performance of a particular stockmarket index like the FTSE-100 (top 100 UK companies by market value). Usually, these have lower charges than managed funds.

The more risky the underlying fund you choose, the more your retirement income may vary - both up and down.

Some unit linked annuities work in a similar way to with-profits annuities. Your starting income is based on an assumed growth rate (similar to the assumed bonus rate). If the fund grows at the assumed rate, your income stays the same. If growth exceeds the assumed growth rate, your income increases. If growth is less than the assumed rate, your income falls. A few unit-linked annuities let you invest in a 'protected fund' which limits the fall in your income.

Most unit-linked annuities do not guarantee any minimum income. Even if your income is based on an assumed growth rate of 0%, your income could still fall if the underlying investment fund falls.

Unit-linked annuities are higher risk than either conventional or with-profits annuities.