Five Things You Should Know About Annuities

1. What is an annuity?

An annuity, usually purchased to provide an income in retirement, is a type of insurance policy designed to deliver a regular income, purchased with a lump sum. The lump sum is the capital you have built up in a pension savings policy.

You are allowed to take up to 25% of your pension savings as a lump sum (tax-free), but the rest must be converted into an annuity.

The amount you get as a regular income in return for your lump sum payment depends on the insurance company you are buying it from. Insurance companies estimate how long you will live and use that as a basis to calculate how much they will pay you.

2. When must I buy an annuity?

Everyone who has built up a lump sum in a pension must buy an annuity by the time they are 75 years old.

There is one exception, and that is those who are part of a final salary scheme. However, these schemes are gradually being replaced, so most people in the future will be faced with buying an annuity when they are 75.

3. What are annuity rates like right now?

With the recent recession and ongoing economic crisis, including the falling stock market, annuity rates have fallen sharply in the past few years. A 65-year-old man can now expect a return of only 8% from his pension fund. This means that if he has pension fund of £100,000, he can expect an annual income from his annuity of just £8,000.

However, you do not have to take the annuity offered by your pension company. As annuity rates vary from insurance company to insurance company, you may get a better rate from another company. If you buy an annuity from a different insurance company, you may be able to invest the money in a different way to better meet your needs, and provide you with hundreds of pounds more per year.

4. Are there any alternatives to an annuity?

There is a way to avoid buying an annuity at 75 (apart from having a final salary scheme). In April 2006 it became possible to use income drawdown after the age of 75. In June 2010, the maximum age for income drawdown was increased to 77, and in April 2011 the age limit was abolished altogether. Thus, people can now stay in income drawdown for as long as they live. If you die during income drawdown your heirs can inherit the remainder of the fund.

Although drawdown is a flexible way of providing a pension income, it does have extra cost and risk.

Income drawdown means leaving the pension fund invested and taking an income from it.

Capped drawdown you can opt to take no income at all or up to 100% of the limit for your age. At any time you can stop and buy an annuity.

There are risks associated with drawdown.

For example, delaying buying an annuity may result in a lower annuity rate when you do come to buy one.

Another example: buying an annuity later in life will naturally make it worth less. Based on cross-subsidy, people with poor life expectancy subsidise those with longer expectancy. So an annuity bought at 70, rather than 60, will mean you don’t get the subsidy from all those who dies in those ten years.

Another point to make is that annuities – once bought – are not subject to any charges, whereas drawdown schemes are subject to management charges, administration charges and review charges.

Income drawdown is probably most suited to those with large pension funds and some other form of income.

5. You should shop around

It is worth shopping around for your annuity rather than simply relying on the pension funds providers you’ve saved with.

Steven Lowe, management board member of the Pension Income Choice Association said in October 2011: "Given that people may be in retirement for ten or 20 years, we are talking about thousands and thousands of pounds. So shopping around seems to reward customers."

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