What you need to know about annuities

On retirement, many of us will need to buy annuity to provide an income. But what is an annuity? Tim Bennett explains the different types, and what you need to know about each.

Planning to retire at 55? Well you'd better get cracking on saving for it.

A recent survey by insurer LV=, found that the number of people planning to put off retiring because they can't afford to has increased dramatically over the past two years.

And a good part of the reason for their pessimism is annuity rates.

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What are annuities?

Some of you will never have to worry about annuities but you are part of a dwindling pool.

The state and some companies provide defined benefit pensions whereby you are guaranteed a proportion of your final (or average working life) salary on retirement. This is also known as a final salary arrangement.

But companies are phasing these out because they are too expensive to run. And even the government is asking state employees for bigger contributions. So these are increasingly rare you should take advantage if you have access to one.

For the rest of us, the deal is much less certain. You and your employer can contribute to a savings plan on a "money purchase" basis.

Since the amount you put in is fixed as a percentage of your salary (say 5% from you and 5% from your employer) this is known as "defined contribution".

The main advantage cited for saving this way is tax. As a higher rate taxpayer, for example, every 60p you invest effectively becomes £1 added to your pension pot, thanks to tax relief.

The problem on retirement however is two-fold. First, although you can make an educated estimate, you have no true idea until you get there what the pot will be worth.

Secondly, unless you manage to build a very large pot, you will face navigating the annuity minefield when it comes to turning your savings pot into an income.

When you buy an annuity, you hand over a lump sum (usually your pension fund, although you can withdraw up to 25% of it as a tax-free cash lump sum first) to an insurance company in return for a regular, guaranteed income for the rest of your life. Under the current rules the earliest age you can do this is 55.

This income is taxable if it exceeds your personal allowance. But there are different kinds of annuities. You need to understand these when buying them.

Annuities come in different shapes and sizes

The most basic annuity is a level annuity. This pays you a fixed income for the rest of your life. It will not change if prices rise. So in an inflationary world, the purchasing power of this type of annuity will go down every year.

For example, if inflation averages 4% a year, the purchasing power of your annuity income will halve in 18 years. If you die, the income paid from this type of annuity usually stops.

If you are worried about rising prices, you could buy an increasing annuity. Here, the amount of income you receive will increase in line with inflation each year, or by a set percentage instead.

If you are worried about your insurance company keeping a large chunk of your pension fund should you die after only a few years of retirement, you could buy a guaranteed annuity.

For example, if you bought a five-year guarantee, and you died after two years, your nominated beneficiary (say your husband or wife) would receive annuity income for another three years.

Another option is a joint-life annuity. This is where your partner can receive some or all of your pension income if you die before them.

If you want to take a bit more risk, you could go for an investment-linked annuity. Here you start with an initial level of income while your fund is invested in an insurance company's with-profits-fund. If the fund makes a profit, your income goes up. If it loses money however, your income goes down.

What do you get for your money?

Annuity rates have tumbled in recent years. There are two main reasons for this.

Firstly, people are living longer. This means that insurance companies have to keep paying incomes for longer.

Secondly, and more importantly, falling interest rates make it harder to generate a source of funds to pay annuity income.

At the moment, according to broker Hargreaves Lansdown, a 65-year-old male with a £100,000 pension pot can expect an annual income of just under £6,000 if he buys a single life, level annuity. This shrinks to little more than half if he wants his income inflation-proofed by having it linked to the retail prices index (RPI).

However, you may get a higher income if you are a smoker or have an illness. Here the annuity provider is betting that you won't live as long so it can pay you more. This is often known as an enhanced annuity or impaired life annuity.

So should you buy an annuity?

If you are retiring just now, low annuity rates probably make you wince. However, that doesn't mean you should necessarily ignore them. They still have some good things going for them.

Once you have bought your annuity, the income you receive is effectively free of investment risk. That has been transferred to your provider. There is also little danger of running out of money, as your provider has to pay you for as long as you live.

However, if you don't want to buy an annuity now because of low rates, there are a number of strategies you can turn to.

One option is known as phased retirement. This is where you set up a series of annuities and drawdowns with 25% tax-free lump sums. You will get a lower starting income, but if you think annuity rates are going to increase it might be worth considering.

Another possible option is fixed-term annuities. Here you set up an annuity for a fixed period, say five or ten years. You get paid an income for the fixed term but at the end of the period, you have a guaranteed pot of money to reinvest again. As with phased retirement, your income will be lower than from a standard annuity.

IMPORTANT! You must shop around

When you buy an annuity, remember to shop around. You don't have to take the offer from your existing pension provider; you are free to go to any provider.

Some providers are pretty cagey about publishing their rates but this is due to change, if the Association of the British Insurers gets its way.

The extra pension income you could get is significant on an enhanced annuity for example, LV= reckons that the difference between the current worst and best buys is almost 50%! Given that you won't get another chance to choose an annuity, it's vitally important that you make the effort to find the best one.

Is income drawdown a better strategy?

These days you don't have to buy an annuity at all, provided you have a sufficiently large pot. Instead you can leave your pension fund invested and take a regular income from it.

The maximum amount you can take each year is determined by your age and government actuary department (GAD) rates based on 15-year government bond yields.

At first glance, income drawdown seems quite appealing. You get to remain in control of your pension fund.

But it's worth noting that you can't take any more income than you could with an annuity. And the big risk is that your fund can remain exposed to the investment markets (unless you hold it all in cash). This means your fund could go down in value and limit the amount of income you can take from it. You don't have this risk with an annuity.

Another risk is that you could run out of money. You could live longer than your fund's ability to pay income. Again, with annuities you don't have this risk.

Four top tips

To sum up, many of us will be dependent on annuities for at least part of our retirement income. That makes it vital that you follow four rules.

First save as much as you can as early as you can and let the power of compounding work its magic.

Second keep tabs on the growth of your pension pot (you should get an annual summary from your provider) and make sure that you are happy with the fund's performance and that the estimated future growth rate isn't too optimistic anything above 5% is frankly too bullish to base your expectations on.

Third, shop around when it comes to finding an annuity.

Fourth, don't put all your eggs in one basket. The problem with the current annuity rules is they are inflexible should you need to get to your money early for example. So make sure you are using up your annual individual savings account (Isa) allowance as these offer tax-free savings, but with the ability to withdraw your money when you need it.

This article is taken from our beginner's guide to investing, MoneyWeek Basics. Everything you need to know about how to invest your money for profit, delivered FREE to your inbox, twice a week. Sign up to MoneyWeek Basics here .

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.