How to buy the right annuity
Buying the best annuity for you is a crucial decision. Here's how to get it right.
This is a classic lovemoney.com article which has been updated for 2010.
With average pension income shrinking every year, it's vital you make the right decisions when you reach retirement to stretch your pension pot as far as possible.
When the time comes for you to take benefits from your pension, the chances are you'll need to buy an annuity. An annuity is a pretty simple concept: it converts your pension pot into an income which finances you during your retirement for the rest of your life. Sounds straightforward enough, doesn't it?
As you get near to your retirement date, you'll receive a quote from your pension company which tells you how much income it's willing to pay you based on the value of your pension.
Most people stop there - but that could be a big mistake. There's a good chance your pension company won't provide the most generous annuity. This means you need to shop around for a better quote, just as you would for say, car insurance.
But before you do that, and this is where it gets a little more complicated, you need to decide what type of annuity you need.
Annuities come in all shapes and sizes, with different sorts of benefits. Here's a quick run-down of the different types. For each benefit you could choose, I'll show you the impact it could have on the income you'll receive.
A guarantee period
Without a guarantee period, your annuity will only last as long as you do. If you only live for a year after buying your annuity, the rest of your pension fund - which hasn't yet been paid out to you - will be completely lost to your heirs. But, by buying an annuity with a guarantee period you can ensure your income is paid out for at least, say, 10 years, and more if you survive longer.
So if, for example, you have an annuity which is guaranteed to last for 10 years but you die after three, your income will continue to be paid to your spouse/dependant for the remaining seven years.
Impact on your income - A guarantee period usually has very little effect - and sometimes no effect at all - on the level of income you'll receive. For this reason, I think you should always include it when you ask for a quote.
Level or increasing annuity
A level annuity means your income will always be fixed at the same amount. This means your income won't keep pace with inflation and your purchasing power will gradually be eroded over time.
The alternative is to get an increasing annuity, which will either rise in line with inflation or by a fixed percentage each year. This way, the value of your income is protected from the effects of rising prices.
Impact on your income - A level annuity will provide you with a higher income initially but its value will erode. However, with an increasing annuity, your income will be much lower - initially it can be around 40% less - but it will rise each year and eventually overtake the income you would have received from a level annuity if you survive long enough. Inflation-proofing your income is a good idea but only if the lower starting income is sufficient.
Single or joint life annuity
A single life annuity will provide an income for you alone, whereas a joint life annuity will pay out an income to you and then your spouse, partner or financial dependant after your death. They could take an income of half, two-thirds or equivalent to the amount you were receiving.
Impact on your income - A joint life annuity provides a lower income than single life because it may need to pay out beyond your death. If your spouse/dependant has sufficient income provision of their own, this may not be necessary.
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This is a special type of annuity which allows you to receive a higher income if you have a lower than average life expectancy. If, for example, you're a smoker, you're overweight or you suffer from high blood pressure you could be eligible for a better annuity.
Impact on your income - An enhanced annuity can boost your income so it's crucial to ask whether you qualify when you're shopping around for a quote.
Impaired life annuity
This is similar to an enhanced annuity but applies if your life expectancy is seriously below average. This might apply if you're suffering from a serious medical condition such as certain types of cancer, liver or kidney disease. If you have suffered a stroke or heart attack you may also be eligible.
Impact on your income - An impaired life annuity could provide an even higher income than an enhanced annuity. It's imperative to ask if you qualify because it could mean up to 40% more income in some cases.
These days some annuities providers take into account where you live when calculating annuity rates. These are known as postcode annuities. The idea is that people who live in areas which are considered deprived are likely to have a lower life expectancy, and therefore they could benefit from higher annuity rates because the annuity is likely to pay put an income for a shorter period. The reverse is true for people who live in more affluent areas.
Impact on your income - A postcode annuity could increase or decrease your pension income depending on the are where you live. If you think you might be eligible for an uplift, it's worth asking annuity providers who offer postcode annuities for a quote.
Don't underestimate how important choosing a suitable annuity is because that decision will affect your financial well-being for the rest of your life. Get it right and you might even be in the enviable position of receiving more income in retirement than you actually need.
The financial side of retirement can be complex. If you need more help, remember you can ask the lovemoney.com community for help using our excellent Q&A forum.