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Annuities explained

An old couple admiring the viewTurning your pension into retirement income is a massive financial decision. We explain how to get it right by exploring annuities.

When you retire, you will need to turn your pension savings into a regular income. To do this, you can buy an annuity, which guarantees you an income for the rest of your life.

While under current rules, all Britons with a pension pot are forced to exchange this for an annuity no later than age 75, the new Con-Lib coalition government has announced plans to scrap compulsory annuitisation at 75.

This move allows more flexibility for pensioners in their later years, as those keen to keep control of their funds would be able to continue to use a “income drawdown” facility or unsecured pension to take small chunks of money out of their pot directly, but leave the rest invested in the stock market.

As it stands, the requirement to purchase an annuity by age 75 will cease from April 2011, after which, a consultation will be launched and new legislation introduced.

But whatever happens with the law, turning pension savings into income needs to be done at the start of retirement – and given that this is one of the most important financial transactions you may make in your life, it's crucial to make the right decision.

Read on for our guide to navigating your way through the annuities maze to ensure you maximise the income you receive on reaching retirement.

Open market option

Several months before you retire, you'll receive a letter from your pension provider offering you an income from the money you've saved. But while it may be tempting simply to accept this offer, the most important thing you can do is shop around because you could increase your pension income by 40 per cent by doing so.

People converting pension savings into an annuity have the right to choose what is known as the “open market option” (OMO), rather than accepting the offer from their pension company.

By exercising the OMO and comparing annuity prices, you can ensure you are getting the highest market rate, as your provider may not be offering the best deal.

This is particularly important at a time when annuity rates  are on a downward spiral, and with further cuts expected amid the current political turmoil, rising inflation, and the prospect of further economic uncertainty in Britain.

Choose the right type of annuity

When it comes to choosing an annuity, there are many different types to choose from.

Level annuities pay a flat rate year after year, with no increase, for the rest of your life, and tend to be the most popular as they offer the security of a fixed income.

However, this security comes at a price, as while level annuities pay a higher starting income than other types, inflation means the buying power of that annual amount will reduce each year.

At the same time, you also need to choose between a single-life and joint annuity.

With a single-life annuity, the income will cease on your death and your partner gets nothing, so couples with only one pension fund between them should think about taking out a joint life annuity.

While this will pay less than a single life annuity, this will continue to pay your partner a portion of the income you were receiving until he or she dies.

Another option is a guaranteed annuity which will continue to pay out for a set period, even if you die within that time.

If, for example, you buy a five-year guarantee, the insurance company would pay five years' worth of annuity income to your estate on death; without such an add-on, all income benefits stop upon death. Learn more about annuities here.

Consider protecting your annuity against inflation

If you don't want to see your pension income eroded by inflation, you can safeguard against this by choosing an inflation-linked annuity, as this will keep pace with rising prices.

However, this type of annuity is much more expensive than a level annuity, and will mean starting at a much lower level of income.

A cheaper option is an “escalating” annuity which increases your income by a fixed amount each year, but even these are still expensive.

Another way of hedging your bets - for those prepared to take some risk in return for growth - is an investment-linked annuity.

These can potentially offer better returns in the long run, but management charges can be hefty and the annuity income paid is based on the ups and downs of the stock market.

A further alternative is to split your pension pot across different types of annuity with several providers - using some to buy an investment-linked annuity and the rest to buy a conventional annuity - helping to diversify and reduce risk.

Maximise returns with an enhanced annuity

If you have a serious health problem that means your life expectancy is likely to be shorter than average, such as a heart condition, cancer, diabetes or kidney failure, you could get an impaired or enhanced annuity.

This pays a higher monthly sum - giving your retirement fund a significant boost. The same applies if you're a smoker or if you're obese.

Buying an annuity is one financial transaction where it pays to come clean about any health problems you have.

Some providers also offer so-called “postcode annuities” - enhanced rates for people who live in areas where life expectancy is lower than normal.

Don't delay getting an annuity quote

Predictions that inflation could return in the medium term would ordinarily be good news for annuity rates - because they are based on gilt yields which tend to rise in line with inflation.

However, the general view is that with annuity rates sliding - and expected to keep falling - it is unlikely that anyone currently considering taking their pension benefits will be better off deferring their annuity purchase.

Annuity rates look disappointing now, but it's important not to be influenced by short-term market movements, as those who delay taking an annuity rarely enjoy dramatically better benefits; in short, you're better off getting an annuity quote sooner rather than later.

One option for those with larger pension pots is to consider buying one annuity now with some of their money, and then buying more in future.

While nobody can predict whether annuity rates will rise or fall in the next few years, and what will happen to inflation, by taking an active role in buying your annuity and shopping around, you can ensure you get the best deal.

And finally, don't forget that it's vital your get it right first time around, as there's no option to switch it or sell it further down the line. When you have purchased an annuity, it is for life.




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Esther Shaw

Esther Shaw

Esther Shaw is a regular contributor to Confused.com and is the former deputy money editor at The Independent and Independent on Sunday. Before that, she worked as a money and City reporter on The Daily Express and Sunday Express.
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