Are annuities really such a bad idea?

The 2014 Budget changed the entire landscape for retirement and saving. But are annuities really such a bad idea?

Most people with pension pots use their pot to buy an annuity. That annuity gives them a guaranteed income for the rest of their lives.

So you could give £100,000 to an annuity provider and you would then receive an annual income of, say, £6000 a year until you died. (The size of your annuity depends on a range of different factors including your age and health.)

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You can buy a range of different annuities. These include:

Level annuities

Escalating annuities

Single life annuities

Joint life annuities

The problem

There have been two main reasons for decline in payout rates. Firstly, life expectancy has grown; and secondly, gilt yields have crashed. Annuity rates are closely linked to long-term gilt yields as yields rise, annuity rates for new retirees go up. And vice versa.

Admittedly, annuity rates did go up last year thanks to rising gilt yields but current rates are still at very low levels. So if you're a 65 year old in good health with a £100,000 pot, you could get a level annuity of roughly £6,000 a year.And if you wanted an index-linked annuity, you'd get roughly £4000 a year.

These rates clearly aren't great. You'd have got much more money if you'd bought your annuity in the nineties roughly twice as much or more.

Annuities are also very inflexible. Once you've bought your annuity you're stuck with it. There's no going back. You also won't benefit from any rise in the stock market.

Plus points

What's more, if you have any health problems when you buy the annuity, you may be able to get a bigger payout known as an enhanced annuity'.

Even relatively minor conditions such as high blood pressure can boost your payout. The same is true if you're a smoker or heavy drinker.

Get the best possible deal

So if you have any health problems or you're a smoker, you must tell the provider during the application process. Also make sure that you shop around and get quotes from a wide range of providers. Annuity Direct and Hargreaves Lansdown are two sites where you can compare quotes.

Don't forget the lump sum

Even after you've taken the tax-free lump sum, you don't have to put all of your pot towards an annuity. You could, for example, put half of the remainder into income drawdown, and use the rest for an annuity. That way, you're getting a nice mix.

Look at this example:

Steve

He has a pension pot of £300,000. He also has £10,000 in a savings account. He has no other assets or income apart from the state pension. His state pension is £5,880 a year.

Steve can take a £75,000 tax free lump sum from his pension pot. He then has £225,000 left. He could spend £125,000 on a level annuity which could give him a guaranteed annual income of £7,500 a year.

Then he still has £100,000 which he could put into flexible drawdown. Then he can take as much or as little as he wants from this pot. He can also decide how the drawdown pot should be invested and hopefully achieve some growth that way.

Delay your annuity

So you could put your pot into drawdown now, with a plan to review your strategy in five years' time. By then, annuity rates may be higher, and you may think they're a more attractive product at that stage.

Guaranteed rates (GAR)

So you might find that your pension allows you to buy an annuity which pays out, say, 10% a year. If you're lucky enough to have a guarantee like this, it might be worth taking advantage.

If you're not sure whether you have a guaranteed annuity rate on your pension, speak to a good financial adviser who can check for you.

Different strokes

But if you want to get a secure retirement income, annuities work for some people. Different strokes for different folks.

This guide is taken from our FREE Pensions Survival Guide', to get the full report click here.