Rates for annuities have been steadily increasing in recent years, with annuity sales hitting record levels in 2023, according to the Association of British Insurers (ABI). If you are close to retiring, deciding whether to get an annuity or not is probably the most important financial task you have to think about. But far too many people don't actually understand what they are.
At its simplest level, an annuity is a contract between you and an insurer. In return for your pension savings, the insurer agrees to pay you an annual income for the rest of your life. And that's it. If you understand that, then you understand the basics of annuities.
So, with the introduction of pension freedoms in April 2015, new rules gave the over-55s much more flexibility with their pension savings. Since then, you have more options for what to do with your pension pot, including taking a tax-free lump sum and flexible drawdowns. Alongside those changes, more providers now offer annuities further expanding people's choices.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
So, with that in mind, here’s everything you need to know about annuities.
Lifetime annuity
A lifetime annuity will pay you a set income for the remainder of your life. It could be a sensible option if you expect your living costs to remain roughly the same over the coming years, or if you are concerned about your pensions lasting as long as you do. This option also has no investment risk, so you don’t need to worry about the value of your money going up or down.
The risk is you may get less back than you paid for your annuity and there is no money left for your beneficiaries, although some providers do offer a lump sum when you die. This will very much depend on the provider you choose, so check the small print.
Level or escalating annuities
Level annuities do what they say on the tin. They stay at the same level throughout the entire span of the annuity. You can also buy an escalating annuity, where the money you receive increases each year, at a fixed rate.
Inflation-linked annuity
Living on a fixed income can be a frightening prospect when you consider the ongoing impact of inflation. You can get annuities that are actively linked to inflation. And you probably should.
Be aware however that you will pay extra for the peace of mind. Your initial payments will be much lower with an inflation-linked annuity than with a standard one.
Fixed-term annuity
A fixed-term annuity offers a guaranteed income for a set period of time, typically between five and 10 years, but they can stretch up to 40. When you take out a fixed-term annuity, the provider will take your money and invest it on your behalf. This sum is then returned to you with the added investment growth, but minus the money you’ve been paid throughout the fixed period.
This offers a good degree of flexibility down the line, as you can use the returned sum to buy another annuity, or any other form of retirement income.
The maturity amount you receive at the end of the term is set when you take out the product. A lower annuity income will result in a higher maturity sum and the end, and vice versa, and the money can usually go to a nominated beneficiary should you die before the term is up.
Investment-linked annuity
These products introduce a degree of investment risk to the decision-making process. Here, part of your income is guaranteed, much like a regular annuity, while part is linked to investment performance. You get to decide what level of guaranteed income you’re happy with, and the remainder of your pension pot is invested, paying additional income based on the returns.
In periods where markets are doing well, you stand to receive additional money on top of the guaranteed payment, but you could also lose money if markets perform poorly.
Enhanced annuity
Enhanced annuities are available to people who aren't, or aren't likely to be in particularly good health, with conditions including diabetes, cancer, high blood pressure, as well as whether you are a smoker. As a result of the fact that their recipients may have reduced life expectancy, these types of annuities can pay out as much as 20% more than a standard annuity.
If you choose this product you'll undergo a fair amount of medical questioning.
Single-life or joint annuities
A single-life annuity is one that pays an income to you, alone. So when you die your spouse or partner will lose that stream of income. You could opt for a joint annuity instead that will continue to pay out to the surviving partner upon your death.
You will get a lower rate each year for this type of annuity as the insurer knows they are likely to be paying out for longer but it is a safer bet. Your partner won't thank you if you hand over your entire pension fund for a single life annuity and die two years later leaving them with nothing.
How to buy an annuity
Your pension provider will get in touch with you once you are near retirement age, and they present you with options on how you can use your pension pot, including buying an annuity. But note: you don’t have to go with your existing pension provider – you’re free to shop around. In 2023, 64% of annuity buyers bought an annuity from a different provider, according to the ABI. And, since annuity rates can vary by as much as 20%, according to Which?, checking to see if you can find a better deal elsewhere could make a real difference to your retirement income. The government’s MoneyHelper scheme has an online comparison tool for annuities, allowing you to compare the rates other providers are offering.
A financial adviser may also be able to help you secure a product that aligns with your financial circumstances and retirement ambitions.
It could be that you buy an annuity with a small amount of your overall pension savings at age 60, for example, while you wait to claim your state pension. Later in retirement, you can either choose to buy another annuity (the rate will be better the older you are) or to take cash out of your pensions using pension drawdown.
Remember, once you buy an annuity it’s usually an irreversible decision, so it pays to think carefully before buying one.
Factors affecting annuity rates
There are a number of factors that will affect what annuity rate you are offered: including age, gender and health. Basically, the sooner insurers estimate you will die the more money you will get.
However, another important factor that governs annuity rates is the yields on government and corporate bonds. This is because insurers typically take pension funds and invest them in bonds. They then pay you your income from the money they get from the bonds. When bond yields are low, the insurers are getting less money so they offer new annuities at lower rates.
-
Revolut finally bags a UK banking licence – what's next for the fintech?Revolut has finally been granted a UK banking licence following three years of negotiations with the regulator
-
Could Labour impose a “double death tax” of more than 50%?Speculation is mounting that capital gains tax will be reformed in the Budget - and one option is to charge bereaved families the tax on top of inheritance tax. We explain how it could work
