Money Guide

Seven things to consider before picking your annuity

Updated: Monday 12 March, 2012

By Martin Fagan

Choosing an annuity is one of the most important financial decisions you will make in your life. These are the questions you must ask yourself first.

An annuity provides a fixed income for the rest of your life and once you have chosen your annuity, you’re stuck with it.

The decision you make will affect your financial well-being for the rest of your days, so it’s crucial that you make your selection wisely. 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.

The following are seven questions that you definitely need to ask yourself before you choose an annuity.

• Do you understand annuities?
• Do you want to withdraw a cash lump sum?
• What type of annuity will suit your circumstances?
• Do you have health problems?
• Are you ready to shop around?
• Have you explored other options?
• Do you need to consult an IFA?

1. Do you understand annuities?

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. Purchasing an annuity is the most common way to turn your pension into an income for life, yet many people do not fully understand the implications of different types of products available. Annuities are complex and you need to understand how they work before you choose one. You can check out our guide, annuities explained, for a basic introduction, but you really should seek professional advice.

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2. Do you want to withdraw a cash lump sum?

When you retire, you can withdraw up to 25% of your pension as a tax-free lump sum. You need to decide whether it’s financially viable for you to do this, and how much of the available 25% you want to withdraw, as this will affect the amount you will have left with which to buy your annuity.

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3. What type of annuity will suit your circumstances?

There are lots of different types of annuity and which is best for you will depend on your own personal circumstances. You need to think about whether you want a single life annuity or a joint life annuity (which will continue to pay a reduced income to your partner or dependent if you die). You will also need to decide whether you want a level annuity, which will provide you with a fixed annual income for the rest of your life, or an escalating annuity that will increase each year. An escalating annuity will pay a lower initial income than a level annuity but will rise over the years, whereas a level annuity is in danger of being eroded by rising inflation. Finding out about the different types of annuity available will help you make an informed decision.

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4. Do you have health problems?

If you are overweight, a smoker, suffer from a range of illnesses from diabetes to rheumatism, these factors could actually help you get a better annuity deal. This is because these ailments will shorten your life expectancy, so will be expected to claim fewer annual payments. Make sure you inform prospective annuity providers of these factors as you may then be able to benefit from a higher annual income with an enhanced or impaired life annuity.

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5. Are you ready to shop around?

As you approach your retirement date, your current pension company will contact you and let you know how big an annuity they will offer you. However, there is a strong chance that this quote won’t be the most competitive on the market, so it’s always worth shopping around. 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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6. Have you explored other options?

Before April 2006, buying a standard annuity was the only option for pensioners, and it was compulsory to buy one before the age of 75. Now however, there are a variety of more flexible options including unsecured pensions, limited-period annuities and value-protected annuities. It’s worth taking look at these other options to ensure that you are making the right decision with an annuity. However, these options are only open to you if you have a huge pension pot - upwards of £50,000 after any tax-free cash is taken - and as the average annuity purchase is £27,000, these options may be out of your reach.

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7. Do you need to consult an IFA?

Choosing an annuity is one of the biggest financial decisions you will ever have to make, so seeking professional advice from an independent financial adviser (IFA) or annuity specialist is likely to be a wise move for most people. An IFA will be able to offer advice tailored to your individual circumstances and help guide you through the decision making process to get the best annuity paying the best rate. And never forget: once you’ve made the decision on which annuity to buy and completed the deal, you can’t reverse it, so an IFA will help ensure the decision you reach is the right one for you.

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