A Closer Look at Purchased Life Annuities

In this article, we look at purchased life annuities, focusing in particular on their taxation and the reasons for and against their purchase – useful for CII R02, R03, R04, R06, J05, J10, AF1, AF4, and AF5 exam preparation.

This article is correct as at 21 November 2023.

What is a purchased life annuity?

Where an annuity is bought with the proceeds of a pension fund, it is referred to as a compulsory purchase annuity and the entire annuity is taxed as earned income.

However, where an annuitant (the person to whom the annuity is paid) uses their own money, for example by cashing in an investment, to buy the annuity, it is referred to as a purchased life annuity (PLA) and the tax treatment differs.

A PLA pays a set amount of income each year for the rest of someone’s life and can, if the annuitant wishes, increase by inflation and also have a guarantee period and/or capital protection attached to it.

How are PLAs taxed?

For tax purposes, the income is split into two:

1. There is a tax-free capital element which is deemed to be a return of the original investment and is calculated using mortality tables.
2. There is an income element which is taxed as savings income.

This tax treatment compares favourably with a pension annuity which is taxed in full, so often individuals reaching retirement will use their tax-free pension commencement lump sum to buy a PLA. 

Potential Advantages of Buying a PLA

There are a number of potential advantages of buying a PLA:

• A guaranteed income for life, to provide peace of mind
• Typically, a greater income than could be achieved by relying on deposit accounts
• Annuity rates are currently high, due to high interest rates
• Income can be indexed, to keep pace with inflation
• PLAs can be bought on a joint-life basis, so an income (say 50%) can continue to be paid out on 1^st death
• A guaranteed term can be chosen at outset, e.g. 5 years, which means that the annuity would pay out for 5 years, even if the annuitant dies sooner
• Capital protection can be chosen at outset which means any capital remaining on your death will be returned to your estate
• If capital protection is not chosen, the PLA will be outside the estate for IHT purposes at outset
• The income element can be set against the personal allowance, starting rate for savings income and personal savings allowance
• Higher annuity rates may apply to individuals with certain health conditions
• Mortality gain; those who live longer than expected will receive more income than their insurer anticipated at outset
• May suit someone with a more cautious attitude to risk / low capacity for loss

Downsides of Buying a PLA

However, there are a number of downsides to consider:

• Income needs change over time, meaning a guaranteed income may provide too much or too little income as circumstances change
• Inflation-proofing will reduce the amount of income paid initially, meaning the annuitant needs to survive a long time for it to be effective
• If capital protection is chosen, then a portion of the sum used to purchase the annuity will return to the estate on death, potentially increasing the amount of inheritance tax payable
• Annuity rates typically rise with age, so delaying purchase could have resulted in a higher income
• Interest rates may fall in the future, so if purchase is delayed may not benefit after all
• Options are only available at outset and once set up cannot be changed (inflexible)
• Mortality loss; the estates of those who die sooner than expected may not receive as much of the capital back as they would have liked
• May not suit someone with an adventurous attitude to risk / high capacity for loss

Grab the resources you need!

If you’re studying for your CII R03 exam, and you want to feel confident on exam day, you’ll need to prepare as much as possible. Grab our free taster to try out one of Brand Financial Training’s resources for yourself.  Click the link to download the R03 calculation workbook taster now!

Alternatively, download a taster resource for AF1, AF4, AF5, J05, J10, R02, R04, or R06 if you are preparing for one of those exams.