What is an annuity?
If you are researching pensions, it's likely you've heard of annuities. Put simply, an annuity is a product provided by an insurer that gives you a secure, guaranteed income for life when you retire. If you're currently paying into a pension pot, you may need to buy an annuity when you reach retirement – essentially, an annuity converts all the money you've been saving up into a monthly or annual retirement income.
There are other ways to take income at retirement – for instance, you can keep some or all of your pension pot invested and draw down from it. However, bear in mind that your money could run out over the years, especially if you live for a long time or spend too much too soon.
An annuity is designed to provide a steady flow of money, no matter how many years you live for after retiring. The amount of income they provide can depend on a number of different factors, including your age when you retire, whether you want it to continue to pay income to your partner when you die, and any medical conditions you have.
How do I buy an annuity?
Normally, your pension provider will send you a "wake-up pack" six months before you retire, containing details about the value of your pension pot, as well as information about annuities and the different types of annuity available to you. You're not locked into purchasing your pension provider's annuity, though: you're free to shop around for a better deal if you choose.
Choosing an annuity can be a complex process, and it's important to pick the one that's right for you. A financial adviser will help to guide you through the different factors involved – briefly, they will ask you:
- Whether you are married or have a partner
- Whether you have any ongoing medical conditions, or are a smoker
- Whether you are concerned about the effect of inflation on your annuity
- Whether you are taking any of your pension as cash, and how many different pension pots you have
Even if you decide not to use a financial adviser, it's certainly a good idea to make use of the Government's Pension Wise scheme: since 2015, retirees have had the "right to guidance" regarding what to do with their pensions, which includes a free, impartial consultation either face-to-face or over the phone. (However, be aware this guidance only covers defined contribution pensions).
Once you have decided which annuity to purchase, complete all the necessary paperwork and it should be set up within 30 days. If you are not using your current pension provider's product, they will transfer the funds to the new provider.
What are the different types of annuity?
Annuities provide different levels of income, but it's not always as simple as selecting the one that gives the most money. Instead, you should make your decision based on what you want out of retirement and what you want for your family and dependents.
You will often see the term "rate" used in connection with annuities. Typically, the annuity rate refers to the amount of income you will be offered compared to the size of your pension fund. This income is also closely tied to your life expectancy.
Some factors that affect the annuity rates you are offered include:
- Age – The younger you are, generally the lower the rate you will receive
- Lifestyle and health – If you smoke or have (for example) a pre-existing heart condition, you may be offered a higher rate
- Where you live and your occupation can also affect the annuity rate you receive
Here are some examples of annuity types and how they work:
- Lifetime annuities
The most common type of annuity available, lifetime annuities give you a guaranteed lifetime income at a rate based on your life expectancy.
If you have a partner, you may choose a joint lifetime annuity, in which a proportion of the income will transfer to your partner when you die.
- Enhanced annuities
These work like lifetime annuities, but they offer higher rates if you meet certain criteria – such as if you are a smoker, are overweight, or have worked in environments associated with chronic illnesses.
Impaired Life annuities are similar products designed for people who suffer from an illness or condition that reduces their life expectancy.
- Temporary annuities
Temporary annuities work differently: instead of a guaranteed income for life, they pay income for a fixed term (such as five years) or until you die.
- Investment-linked annuities
With investment-linked annuities, only part of the income is guaranteed – the rest is linked to the performance of investments the provider makes. This makes them less consistent than traditional annuities, but they can potentially pay out more.
- Purchased life annuities
A purchased life annuity is bought with money that does not come from your pension pot – although you can still buy them with money that you withdrew from your pension pot as a lump sum.
They work very similarly to other types of annuity, although they are treated differently for tax purposes. Part of each income payment is treated as a return of invested capital, meaning you do not have to pay income tax on it.
Can annuities be sold?
Right now, annuity sales are non-reversible. There is a cooling-off period of 30 days after you have signed your contract, during which you can cancel your policy and choose a different one, but after this period, most people have to keep the annuity they have purchased for life.
However, the Government is planning to make some changes to this system. The Treasury and the Financial Conduct Authority are working on rules to create a secondary market for annuities, currently scheduled to come into operation from April 2017.
This will allow annuity customers to provide their age, health information and annuity details to a central body, from which interested buyers will be able to "bid" for their annuity. The exact details of how this will work are still being fleshed out, but it is generally expected that selling an annuity will involve a number of additional charges.
In other words, selling annuities may not turn out to be a very cost-effective proposition, and is likely to only be a good option for people who have found themselves locked into a bad deal. Even if you are considering selling your annuity when the new rules come into force, it's still worth getting the very best deal you can now.
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