Annuities are one of the oldest and simplest of all financial products.  When the Monty Python team famously declared that the Romans had given us nothing but roads, medicine, health, education and fresh water they might have added to their list “annuities”, or, as the Romans called them, “annua”.

Jane Austen declared them to be “a very serious business” in Sense and Sensibility, published in 1811, and nothing much has changed.  Annuities are not only serious but big business, and buying the wrong one can make a significant difference to your standard of living in retirement.

What is an annuity?

Put simply, an annuity is an investment that, in return for a lump sum, guarantees to pay you an income.  In the case of retirement or lifetime annuities this income will be in the form of a pension, guaranteed to be paid for the rest of your life, no matter how long you live.

If you are in a money purchase occupational pension scheme, or have any kind of personal pension, then when you retire your pension fund buys an annuity, although you can normally first take out 25% as a tax-free lump sum (see Guide to Private Pensions and Guide to Company Pensions).

If you can afford to, you can defer buying an annuity, and in the meantime draw an income from your pension fund, which remains invested. This is known as drawdown (see Guide to Drawdown).

The open market option

Annuities are generally sold by insurance companies, but you do not have to buy one from the  insurance company with which you saved for your pension. You can shop around when you retire for the best annuity.  This is known as exercising the “open market option” and you are strongly advised to at least look at what other companies can offer.

The difference between the best and worst annuities can be as much as 20 per cent which over the entire period you are retired can make a difference of thousands to your overall income.  Moreover, the companies that appear in the ‘best buy’ annuity tables are rarely the same as those that top the ‘best pension provider’ polls, meaning it is madness not to shop around. 

A specialist independent financial adviser can help you trawl the whole market. Take a look, for example, at the Annuity Bureau, Annuity Direct or William Burrows.

What are the advantages and disadvantages?

The main advantage of an annuity is that it guarantees you a certain level of income regardless of how long you live, giving you peace of mind that your income will not dry up as you grow older.  

The main disadvantage of a traditional annuity is that, when you die, your pension payments stop.  In a worst-case scenario you could retire, use most of your pension fund to buy an annuity, and die suddenly within weeks.

However, there are options that give certain guarantees, though your starting income will be significantly less than if you opt for a conventional single life annuity.

Guaranteed period

You can choose an annuity that guarantees to pay out for a minimum period even if you die.  This is usually a maximum of 10 years and you can nominate who you would like to receive the income after your demise. 

Protected annuity

A lump sum can be paid out to someone you nominate if you die before the age of 75.  They should get the purchase price of the annuity, less all pension income paid out so far.  However, the payout will normally be taxable at a punitive 35%. 

Joint life annuity

If you have a partner who is financially dependent on you then you should consider a joint life last survivor annuity, which will continue paying an income until the second of you dies.  You can choose to have the same or a reduced amount, say half or two-thirds the original pension. 

What determines how much pension you get?

Obviously the biggest determinant is the amount of money in your pension fund.  However, your age and that of your spouse, if you are buying a joint life annuity, will affect how much income you receive.  The younger you are the lower the pension tends to be, because the likelihood is that it will be paid for longer.

Longevity is a key factor, and as women tend to live longer than men annuity rates are lower for women.

However, anyone who has a health condition that may potentially shorten their life can probably obtain a higher pension. Some annuity providers also offer an increased rate for those who have made less healthy lifestyle choices, such as smokers or people who are overweight. (see Impaired life and enhanced annuities, below).

Are there any other factors?

How much initial income you receive from your annuity will also depend on the type of annuity you choose.  As well as receiving a lower initial income if you opt for certain guarantees, as explained above, whether you choose a level annuity (one that will always pay the same amount) or an escalating annuity (one where income rises at regular intervals) will affect how much pension you receive.

Choosing can be a difficult decision. An escalating annuity will normally increase by a set percentage, say 3% per annum, or it may be linked to the Retail Prices Index, though possibly only up to a ‘capped’ amount.  These pay a much lower initial amount than level annuities, in some cases as much as 35% less, which means it can take several years to ‘catch up’ to the amount you would have received from the outset had you chosen a level annuity. 

However, if you opt for a level annuity and live for many years you may find living on a fixed income increasingly difficult as the cost of living inevitably rises.

To calculate roughly how much income you might achieve from an annuity go to http://www.pensioncalculator.org.uk/

Investment-linked annuities

Another way to potentially achieve an escalating income is to choose an investment-linked annuity.  However, these are not guaranteed as, unlike traditional annuities described above, which are linked to fixed interest assets such as gilts and bonds, they are linked to the stock market. There is potential for an increasing income, but there is also the risk that your income may reduce if the stock market goes down. 

Investment-linked annuities are therefore most suited to people who have another secure source of income in retirement and can afford to take some risk with their annuity.

With-profits annuities

Similar to investment linked annuities, these invest in the with-profits funds of insurance companies and some guarantee a minimum starting income, though this is likely to be low.  Generally, if you take a with-profits annuity, your starting income depends on the Anticipated Bonus Rate (ABR), meaning the level of annual bonus that you think the insurance company is likely to declare.

You choose the ABR from a range set by the insurance company – typically from 0% (which assumes no bonuses at all) to 5%. Once chosen, most insurance companies do not allow you to change the ABR (though some do). If the insurance company declares bonuses higher than your selected ABR your income will increase, but if they declare a bonus rate lower than your ABR your income will reduce.

In recent years bonuses have fallen, making with-profits annuities less attractive.  However, you can normally convert to a conventional annuity if you are unhappy with the performance.

Impaired life and enhanced annuities

It is estimated that some 40% of annuitants could benefit from these. If you are in poor health, then you should certainly qualify for an impaired life annuity.  Relevant problems include cancer, chronic asthma, diabetes, heart disease, high blood pressure, kidney failure, multiple sclerosis or stroke. Even if you are fit and well now, if you have suffered from any serious illness in the past you may still qualify.

Relatively minor health issues, such as being a smoker, having high cholesterol or being overweight, may mean you can get an enhanced annuity. And, even if you decide to quit smoking or go on a diet you’ll still have the higher income as future changes in lifestyle cannot affect your pension once you have bought your annuity. Some companies also offer higher rates to people who have worked in certain occupations, or who live in certain areas of the country.

For more information: Moneymadeclear

New-style annuities

A number of new-style annuities have been launched recently that seek to address the problem of your annuity dying with you.  They aim to offer the best of both worlds, still giving you a guaranteed income, just like a traditional annuity, but allowing the bulk of your pension to remain invested until you are 75, the age at which under current legislation you have either to buy a conventional annuity or an Alternatively Secured Pension (ASP) (see Guide to Drawdowns). Charges on these annuities are also relatively high, but they do enable you to bequeath whatever is left of your pension fund (less tax at 35%) should you die before the age of 75.

These annuities are only offered through independent financial advisers and are most suited to those with relatively large pension funds (at least £50,000). For more information, visit  http://www.annuity-bureau.co.uk/, http://www.annuitydirect.co.uk/ or http://www.williamburrows.com/

CashQuestions Guide to State Pensions
CashQuestions Guide to Occupational Pensions

CashQuestions Guide to Private Pensions

CashQuestions Guide to Pensions for Women
CashQuestions Guide to Annuities

CashQuestions Guide to Drawdown

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