The beginner's guide to annuities

Confused about annuities? You're not alone. According to a recent survey, only 23% of us actually understand what they are. But if you're about to retire, then your annuity is probably the most important financial thing you need to know about. Here, Ruth Jackson sheds some light on the subject.

If you are close to retiring, your annuity is probably the most important financial thing you have to think about.Yet according to a recent survey by the Association of British Insurers (ABI), only 23% of us actually understand what they are. That's not good, particularly as it really isn't complicated. 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 you understand the basics of an annuity.

Until recently everyone had to buy an annuity with their pension when they hit 75. That was shifted to 77 while the government considered matters. However from April things will change so that anyone who can prove their pension income will be more than £20,000 a year will no longer be obliged to buy an annuity at all. However that won't let most of us off the hook: to fall into the £20,000 category you'll need savings of around £300,000.

So, given that most of us will still need to buy an annuity, here is how to go about it.

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Open Market Option

The most important thing to know is that you can shop around for your annuity using your "open market option (OMO)." Your pension provider would very much like you to think that you have to buy one of the options they offer (there is good money to be made in providing annuities) so there is every chance they will fudge the issue when you come to cash in. However using your OMO is absolutely vital annuity rates can vary by as much as 30% so getting the wrong one could make a real difference to your retirement income.

Annuity rates

The annuity rate is the amount of money you will get each year as a percentage of your total pension pot. So if you get a rate of 5% you will receive back 5% of your savings each year so someone with a £100,000 pot would get an annual income of £5,000 a year.

On a personal level there are a number of factors that will affect what annuity rate you are offered: age; gender; and health. Basically, the sooner you are likely to die the more money you will get the insurers don't want to be paying out a large annual sum to a healthy living yoga fanatic who could live another 30 years so they will offer him a lower rate than they will a fat smoker.

However, there is another important factor that governs annuity rates 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 in from the bonds. When bond yields are low, the insurers are getting less money so they offer new annuities at lower rates. Unfortunately, right now, bond yields are low.

The combined effect of low bond rates and increased life expectancy means that annuity rates have been steadily declining over recent years. In 2000, a 65-year-old man could turn a £10,000 pension pot into £866 a year for life. Now that same man would get £607. This makes it more important than ever to save as much as possible into your pension, and then to shop around when it comes time to buy an annuity.

Inflation-linked annuities

The other thing to consider with annuity rates is whether you want to get the same nominal payment every year for the rest of your life or you want it to rise over time. Living on a fixed income can be a frightening prospect when you consider the ongoing impact of inflation. You can get annuities that either steadily increase the amount you get over the years or that are actively linked to inflation. And you probably should. Be aware however that you will pay for the peace of mind your initial rate will be much lower with an inflation linked payment than with a standard payment.

Enhanced annuities

Enhanced annuities are available to people who aren't, or aren't likely to be in particularly good health. Think smokers, asthmatics and the like. Thanks to the fact that their recipients might not live a normal life span, these type of annuity can pay out as much as 20% more than a standard annuity. At the moment a mere 10% of investors that would be eligible for an enhanced annuity both enquire about and buy one, something that means an awful lot of people are missing out.

Single life annuities

Finally, before you buy, think about what might happen after your death. A single life annuity is one that pays an income only to you. 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 dietwo years later leaving her with nothing.

Ruth Jackson-Kirby

Ruth Jackson-Kirby is a freelance personal finance journalist with 17 years’ experience, writing about everything from savings accounts and credit cards to pensions, property and pet insurance.

Ruth started her career at MoneyWeek after graduating with an MA from the University of St Andrews, and she continues to contribute regular articles to our personal finance section. After leaving MoneyWeek she went on to become deputy editor of Moneywise before becoming a freelance journalist.

Ruth writes regularly for national publications including The Sunday Times, The Times, The Mail on Sunday and Good Housekeeping, among many other titles both online and offline.