Become a pensions expert in five days - day 3

by Ed Bowsher on 01 July 2009  |  5 comments
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Here's my lowdown on annuities.

In the first two parts of this series I've explained the main types of pension. I've done this so you can figure out what your current pension position is. But there's one final piece of the jigsaw that we need to look at - annuities.

Annuities is a crucial subject if you have a defined contribution pension. You can't figure out your current pension position if you aren't up to speed on this.

So here's the lowdown on annuities:

When it comes to defined contribution pensions, most people normally convert their pension pots into retirement income via an annuity.

Basically, you give your pension pot to an insurance company, and it then promises to pay you an income for life.

The rate you receive will depend on a number of factors:

• Your age (the older you are, the bigger your income)
• Your health (the healthier you are, the smaller your income)
• Your gender (if you're a woman you'll get a lower rate as women tend to love longer than men.)
• The type of annuity that you buy.

You could buy a 'level annuity' where you receive, for example, £10,000 a year. That sum will never rise during your retirement. If you're worried about inflation, you could buy an 'index-linked annuity' where your income will rise as inflation goes up. However, your income will start at a lower level at the beginning of your retirement. You could also buy an annuity where the income rises by, say, 3% a year.

Similarly, you could buy an annuity that will also support your spouse after your death. Once again, if an annuity covers two people, it will start at a lower level than it would for just one person.

If you want to make sure you get the highest possible annuity, shop around. You don't have to buy an annuity from your pension provider, and the difference between the highest and lowest payers can be substantial, sometimes as much as 20%.

How big an annuity could you get?

Annuity rates have fallen dramatically over the last 20 years. That's largely because interest rates and inflation have fallen too. Rising life expectancy has also been a factor.

As I write, a single 65 year-old male with a £100,000 pension pot could buy a retirement income of £7,171 a year with an annuity from Aegon Scottish Equitable. This example is a level annuity that is just for the man. If the man in this example was married, his wife would receive nothing after his death.

If you want to check the latest annuity rates, visit Hargreaves Lansdown.

Now, I know those last few paragraphs might have scared you. You might think that it'll be tough to build a pension pot as big as £100,000 while an income of £7,171 isn't that much. Well, in a later post, I'll look at how you might be able to save £100,000.

And £7,171 isn't as bad as you might think. If you added the current state pension (£4953 a year) to your private pension, you'd have an annual income of £12,124. If you've paid off your mortgage by the time you retire, you wouldn't be on the poverty line on £12k a year. (I admit you'd be far from rich either.)

Alternatives to annuities

If you've built up a pension pot via a definied contribution scheme, you no longer have to buy an annuity at any stage these days.

Instead you can choose to take an annual income from your pot while the rest of the pot continues to be invested. This is known as an unsecured pension if you're under 75, and an alternatively secured pension if you're 75 or over.

This is a risker option than an annuity because your pension pot will remain invested in the stock market, bonds or both. So the value of your pension pot could rise while you're retired and hence boost your retirement income, or it could fall.

Deciding whether to go for an annuity or an alternative is a big decision. I don't think you should make that decision purely on the basis of reading this article. It could be worth consulting an independent financial adviser (IFA) when you make this decision.

Read part four of this series.