Money Guide

Annuities explained

Written by Hazel Cottrell
hazel.cottrell@consumerchoices.co.uk

What are annuities and how do they work? What should I look out for? (Updated 3/8/09)

Choosing an annuity is one of the most important decisions you will make in your life. Once you have chosen, it can be incredibly difficult if not impossible to change, and the decision will affect your financial well-being for the rest of your life.

In this guide we will explain what annuities are, how they work and what to look for as well as looking at alternative options. Because the decision is so important, it is also often worth consulting an Independent Financial Advisor (IFA).

• What is an annuity?
• How do they work?
• How do I choose?
• Other options?
• Recommendations

Back to the top

What is an annuity?

An annuity is basically a guaranteed income for life paid out by an insurance company in exchange for a lump sum payment. Your annuity provides a fixed annual payment which finances your retirement and continues until you die.

Purchasing an annuity is the most common way to take benefits from your pension. It used to be compulsory, but changes in regulations mean that there are now other options. However, for the vast majority of people, an annuity is still the best option for taking pension benefits.

As you approach your retirement date, your pension company will contact you to inform you how much income it is willing to pay you based of the value of your pension fund.

However, there is a strong chance that your pension company won’t provide the most generous annuity, so it is always worth shopping around for a better offer. This is known as taking the “open market option” and can be very worthwhile – the difference between the highest and lowest offers can be as much as 20%!

Back to the top

How do they work?

Once you have put money into your pension, you cannot remove it as you please. It must remain there until you are at least 50 (or 55 if you are retiring after April 2010). At this point you may withdraw 25% of it as a tax-free lump sum, leaving the remaining sum to provide you with a taxable income for the rest of your life.

Basically this is to ensure that the money you accumulate under the pension tax shelter actually funds your retirement, preventing you blowing your entire pension pot on a world cruise and then having to rely on the state.

The remaining sum will normally be used to purchase an annuity. For example, if your pension fund totals £100,000 you may use this to purchase an annuity which will give you an income of maybe £7,000 a year, every year, for the rest of your life.

This is only an example - the sum you will receive each year will be based on your individual circumstances. The most important feature of an annuity is that it stops when you do. Therefore when annuity providers calculate how much to offer you each year, they must predict how long you will live for and thus how many payments you are likely to receive. They may take many factors into account including your age, gender and whether or not you smoke.

Back to the top

How do I choose?

When deciding on an annuity, you will need to decide what type of annuity will suit your specific needs and choose which provider to buy it from.

There are plenty of things to consider, including:

• Single or joint - Do you need a single life annuity (which pays income to you alone) or a joint life annuity (which will continue to pay income to your partner or financial dependent if you die)?
• Level or escalating - Do you need a level annuity which will provide you with a fixed annual income, or an escalating annuity that will increase either in line with inflation each year or by a fixed percentage each year?
• Guarantee - Do you want an annuity with a guarantee to pay out for a certain number of years, even if you die?
• Impaired life - Are you overweight, a smoker or have health problems? If so you may be able to benefit from a higher annual income with an enhanced or impaired life annuity.

These decisions are complex and each choice you make will have an effect on the size of the offers you are likely to receive. There are further aspects to consider too.

Once you have decided what type of annuity you want, you can shop around for the provider that offers the best deal. Each provider will calculate your life expectancy slightly differently and hence how much to pay you from your pot each year.

Back to the top

Other options

Before April 2006, getting an standard annuity was the only option for pensioners, and it was compulsory to buy an annuity before the age of 75. Now however, there are a variety of other options which provide more flexibility, including:

• Unsecured pensions / Alternatively secured pensions – These allow you to take a limited amount of money out of your pension fund each year as income. This leaves your pension with a lump sum balance that can be passed on to your dependents if you die.
• Limited-period annuities – These last just five-years, after which time you can buy another limited-period annuity or a standard annuity.
• Value-protected annuities – These will pay out any remaining funds from your pension pot to your estate when you die, but produce a lower annual income than standard annuities.
• Cash – If your pension fund at retirement totals less than £15,000 you are now able to simply withdraw the cash, but only 25% of it will be tax free.

These options can be complicated, and before you make any decisions we would suggest that you consult an IFA.

Back to the top

Recommendations

Remember, choosing an annuity is one of the biggest decisions you will have to make in your life and it will affect the rest of your life. It’s important to get the right one, so make sure that you:

• Think carefully about what kind of annuity will be most suited to your needs and consult an IFA if necessary.
• Shop around to get the best quote, just as you would for any other financial product.
• Inform your prospective annuity providers if you are overweight, a smoker or have any medical problems – you may then be offered an increased annual income from some providers.

Seven things to consider before picking your annuity

To start your search for a great annuity, take two minutes to complete our annuity form. We will search the leading annuities providers and upon finding the best rate, will supply you with all the details you need. The quote is free and there is no credit check or obligation to buy.