How to choose an annuity


Turning the pension you've worked decades to build into an income for life, your annuity could arguably be the most important thing you ever buy. Once you have bought it you can't take it back, so make sure you pick the best annuity for you with our step-by-step guide.

Find out what your pension provider will offer you: Six months before you are due to retire your pension provider will send you a retirement pack and will let you know what income you can expect in retirement if you buy your annuity from them. You can always request this information earlier if needs be.

In most cases you will be able to get a better deal elsewhere, however some people who bought pensions in the 1970s and 1980s may have a 'GAR' or guaranteed annuity rate attached to their pension. As these stem from a time when interest rates were so much higher it's likely that the income you get will be higher than that paid by another annuity provider.

The offer, however, may only apply if you retire on your scheme's selected retirement date – for example your 65th birthday. But do be warned that, while the income may be higher, you may not be able to include inflation-proofing or preserve an income for your dependents if you die first.

Shop around: Armed with this knowledge, use a comparison website to find out what rival providers will be able to offer you. These websites will ask you a series of questions, just like a car insurance comparison service, to generate quotes from other companies. They also allow you to experiment with different options to show you what impact they will have on your overall income.

Find the best annuity rate for your circumstances

Fess up to any health problems or vices: Admitting you smoke or drink large amounts might mean you pay more for your life or health insurance but when it comes to annuities the opposite is true. To be eligible for an enhanced annuity - which pay higher rates to those who are expected to have a lower life expectancy - you don't have to be seriously ill.

Any lifestyle issue such as smoking, drinking or obesity that could give you a reduced life expectancy may mean you can get an enhanced annuity. The same applies with health complaints including diabetes, raised blood pressure or cholesterol.

Hargreaves Lansdown claims that 56% of retirees would qualify for an enhanced annuity and says that a smoker with high blood pressure and cholesterol readings could increase their income by as much as 47% by opting for this type of annuity.

Single or joint? You can opt to have a single annuity that stops when you die, or a joint one that carries on paying until your spouse dies too. You can opt for 100% of the income to be paid after your death, or a reduced proportion such as two-thirds or half. Single life annuities will pay the highest income, but failure to purchase protection for a spouse could have dire consequences if you die first and don't have enough alternative sources of income.

Do you want guaranteed payment periods? An annuity without any guarantee will stop paying when the policyholder dies, and no money will be returned to their estate. To prevent this happening you can purchase a guarantee that will ensure your income is paid for a minimum period if you die early on in the contract. A five-year guarantee would therefore pay out for a minimum of five years – so if you died after two years, your family would receive your income for a further three years, or if you died three years into a 10-year guarantee, payments would carry on for another seven years. Most annuities are sold with a five-year guarantee.

Do you want inflation protection? You will also be asked if you want to receive a level income that remains the same for the duration of the policy or an escalating one that increases with inflation. The level income will be higher at the outset, but the escalating option will increase with time. You can either opt for fixed percentage increases – say 3% a year – or increases that are directly linked to the inflation measure, the retail price index (RPI).

In the current climate, with inflation running above target, inflation-linking might seem like a no-brainer, but recent research from MGM Advantage found that you may have to live a very long time before inflation-linked plans start to offer serious value for money. Taking the example of a £100,000 annuity over the typical 22-year retirement, it found that a level annuity paying £5,743 a year would pay out a total income of £126,346, but an RPI-linked plan paying £3,331 at outset rising to £6,197 in the final year would only pay out £101,718 in total. An escalating annuity rising at 3% a year would start out paying £3,929 rising to £7,309 in the 22nd year, paying out a total of £119,979.

MGM's research found that an investment-linked annuity might offer better protection against inflation. The same £100,000 pot would buy a starting income of £5,740, rising to £7,895 in year 22 and paying out a total of £145,655. However, because these plans remain invested and there is the potential for your income and capital to fall, they are only suited to wealthier investors with a higher tolerance for risk.

Double-check you are getting the best rate: Once you have found the insurance company that will give you the best annuity for you, you're ready to apply. However if during the application process you make any changes, for example adding in some spouse protection or inflation proofing, it's important to go back out to the market and shop around again. For each different set of requirements, different providers will come out on top.

Still not happy? Check out the alternatives:

From April 2015 all savers will be able to use their pension funds as they wish, follwing an announcement in the 2014 Budget. Interim measures also mean savers can also cash in more smaller pensions, so it may be that an annuity isn't the right option for you.

Those with small pensions may take the opportunity to cash in their pension and take it as a lump sum (75% of which would  be taxed). Those with more sizeable funds may look to leave their money invested and go for income drawdown – this gives you the ability to retain control of your money and you can vary the income you receive as and when your circumstances change. Unlike annuities you will have a choice of death benefits – your dependents could convert the fund into an annuity, carry on taking an income, or take a lump sum (less tax at a current rate of 55% although this is expected to fall). 

Take advice: Every layer of protection you work into your annuity will reduce the monthly income you receive. As a result it can be difficult to strike the appropriate balance between your financial needs now and the needs of you and your family further down the line. If you're in any way unsure, or don't think an annuity is appropriate for you it is well worth paying for independent advice.

Advice can be expensive, but if you come out with a higher income as a result, or an arrangement that is better suited to your needs, it's a worthwhile investment. Savers with small pensions may not be able to justify paying for advice – however there is a wealth of research that can be done online to ensure you make an informed choice.

Your Comments

The text above satets "Taking the example of a £100,000 annuity over the typical 22-year retirement, it found that a level annuity paying £5,743 a year would pay out a total income of £126,346, but an RPI-linked plan paying £3,331 at outset rising to £6,197 in the final year would only pay out £101,718 in total."
And this calculation is based on paying out for 22 years.

To just give you back your capital with a measly £1.718 for keeping (and investing for growth) your money for 22 years is PROOF (if proof were needed) that annuities with RPI increases can be VERY POOR VALUE.
And if you look at a selection of annuities available, the majority that I have looked at fall far below this return.

Don't forget as well that annuities are income and are taxable.