Buying an annuity is one of the most important financial decisions we can make.
Annuities are used to turn a pension fund, which in many cases is worth hundreds of thousands of pounds, into an income for life.
And once you have chosen your annuity, there is no going back – which makes picking the right type absolutely crucial. (See our beginners guide to annuities.)
The biggest decision
Perhaps the most important choice to make when buying an annuity is whether to have annual increases in the income you receive.
The most basic type is known as a level annuity: as the name suggests, this pays out a fixed rate of monthly income for the rest of your life.
But, as the current economic climate has made only too clear, those coming up to retirement must also bear in mind the possible impact of inflation.
Over time, inflation means that the value of the income generated by a level annuity shrinks.
How fast it shrinks depends on how high inflation goes, and for how long it remains high.
But by opting for a level annuity, you are effectively gambling on inflation not having too serious an impact.
Protecting your income
As an alternative to a level annuity, you could go either for an escalating or an inflation-linked annuity.
The income produced by escalating annuities increases by a fixed amount every year, for example 3 per cent. An inflation-linked annuity will rise in line with an inflation index – normally the retail price index (RPI).
With the latter option, your income in retirement is guaranteed to keep pace with prices; an escalating annuity, on the other hand, could see your income rise more or less quickly than inflation.
The price of protection
The cost of protecting your income against inflation can, however, be significant.
If you opt for an annuity which increases income every year, your starting level of income will be much lower than that from a level annuity.
Figures from the Financial Services Authority suggest that, based on current life expectancy rates, it would take around 14 years for the income from an annuity escalating at 3 per cent a year to catch up with the level annuity.
And it would take 26 years before the total you received from the 3 per cent escalating annuity exceeded the total paid by the level annuity.
Essentially, the longer you live after taking out your annuity, the more valuable any annual increases will be.
Making your choice
There are a number of factors that can help you decide whether to go for a level or escalating annuity.
If the annuity you’re buying is going to be your main source of retirement income – alongside the state pension, for example – it is more likely to be worth choosing one that increases every year. This is because you do not want to risk your income to be effectively wiped out over time by inflation.
But if your pension pot is relatively small, you may be happy to use the state pension and means-tested benefits such as pension credit as a safety net, so a level annuity could be more appropriate.
