Money Guide

Annuities explained

Monday 12 March, 2012

By Martin Fagan

What are annuities and how do they work? What should I look out for?

Although we say people in retirement are “living off their pension”, what we actually mean is they’re living off the income produced by their annuity. And choosing an annuity is one of the most important financial decisions you will make in your life. Once you have chosen, it’s impossible to change, and the decision will affect your financial well-being for the rest of your life. Annuity purchases are rather like an Apollo spacecraft returning from the moon and preparing to re-enter the Earth’s atmosphere - you have only one chance to get it right. Screw it up and disaster looms.

In this guide we will explain what annuities are, how they work and what to look for as well as considering at alternative options. Because the decision is so important, it is imperative you consult an Independent Financial Adviser (IFA) or annuity specialist.

• What is an annuity?
• How do they work?
• How do I choose?
• Other options?
• Things to bear in mind

What is an annuity?

An annuity is a contract between an insurance company and an individual, where the individual hands over all (or part) of their pension fund to the insurance company which, in turn, agrees to pay out an income to the scheme member for the remainder of that person's life.

That’s important to note - although it’s paying your income for the rest of your life, it is an insurance contract and the payout depends on you being alive. Once you die, the payout ceases and there are no refunds or a residue of cash you can leave to your family or next of kin.

Purchasing an annuity is the most common way to take benefits from your pension. It used to be compulsory but, in theory, changes in regulations mean that there are now other options. I say “in theory” because although there is more flexibility in how people take an income from their pension, it often means deferring the point at which you draw income. This means having an alternative source of income for you to live on until you decide to cash in your pension benefits, which is an option open to very few retirees who have no other source or retirement income other than their pension. Therefore, for the vast majority of people, an annuity is really the only valid 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 on 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%.

Annuity rates fluctuate daily and no single life company dominates the best buy tables. This is because, although all life companies offer annuities all of the time, occasionally a life company will seek to get more single-premium business on its books and so, for a limited time, will offer higher annuity rates.

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How do they work?

Because of the tax relief you get on your contributions, once you have put money into your pension you cannot remove it. It must remain there until you are at least 55, although for most people this will be an unrealistically early age to retire - it’s unlikely 30 years in work will have enabled you to save enough into a pension that will finance you through 30 years in retirement. At this point you may withdraw 25% of your total pension fund 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 (the unrealistically high sum the pensions industry bases all its calculations on simply to keep the numbers round) you may use this to purchase an annuity which will give you an income of maybe £6,000 (6%) 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 and how many payments you are likely to receive. They may take many factors into account including your age, gender, pre-existing illnesses and whether or not you smoke.

Annuities are able to provide annuitants with an income for life because the unused funds of those who die earlier than expected help to pay the annuities of those who live on. This process is charmingly called “mortality cross-subsidy”. So the longer you live the better deal you get from an annuity.

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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 a slightly reduced 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 from the day you take it out to the day you die, 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. This is when it pays to engage an IFA or annuity specialist.

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Other options

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 a slightly reduced 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 from the day you take it out to the day you die, 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. This is when it pays to engage an IFA or annuity specialist.

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Things to bear in mind

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 or annuity specialist.
• Shop around to get the best quote, just as you would for any other financial product. This is where engaging an IFA makes sense.
• 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.

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