Five-minute guide to picking the perfect annuity
With many of us now living well into our eighties, if not longer, choosing the best way to take an income from your pension is more important than ever.
However, many pension providers fail to highlight what your true options are, which means many people end up making a decision that can have adverse financial effects.
To avoid falling into this trap, here we answer the key questions you should consider before reaching a decision.
What is an annuity and how do they work?
An annuity is an income for life provided by an insurance company in exchange for your pension pot.
When you reach state retirement age - currently 60 for a woman and 65 for a man - you have the choice of purchasing an annuity or deferring for as long as you wish until you're 75.
There are many different types of annuity on the market. You can buy a single or joint annuity, one that remains level or increases with inflation, or in some cases an enhanced annuity - depending on your individual circumstances.
Just remember that once you've picked one, you can't change your mind.
Do I have to buy one from my pension provider?
Your pension provider should contact you in the months leading up to your retirement to inform you of the annuity rate it can offer you. However, you don't have to accept the rate it's offering.
Instead, take advantage of the open-market option - you're allowed to compare rates from other providers to see if you can get a better deal.
According to independent financial advisory firm AWD Chase de Vere, up to 77% of people fail to do this when cashing in their pension, and, as a result, miss out on up to 30% more income each year.
What is an enhanced annuity?
The term 'enhanced annuity' – also called an 'impaired life annuity' – is offered to people with shorter life expectancy.
This is calculated on a number of factors, including whereabouts in the country you live, whether you're a smoker, if you have any existing health conditions, or if you're obese.
According to rightannuity.co.uk, approximately 40% of retirees could qualify for an enhanced annuity rate, which would see them receive an average additional income of 22%.
I'm still earning money, can I wait before taking one out?
At the moment, you can postpone purchasing an annuity until you hit 75, by which point you're legally bound to take one out. The coalition government has announced that it is scrapping this policy, but the time-scale and changes are still to be confirmed.
However, Tim Whiting, spokesperson for the Annuity Bureau, says this will only affect around 2% of the population because "the vast majority of people still want to access their pension accounts before the age of 75".
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.