All About Annuities

One of the restrictions with personal pensions, and for that matter defined contribution company pensions, is that you usually have to use the bulk (generally 75%) of your pension fund to buy something called an annuity before you are 75 years old. You can take up to 25% of your pension pot as a tax-free lump sum when you retire.

What is an annuity?

An annuity gives you an income for life and they are sold by insurance companies. You give the insurer your pension pot and they promise to pay you an income for life.

The rate you get will depend on a number of factors. The younger you are, the less you'll get each year as the insurance company is likely to pay out for a greater length of time. If you're a woman you'll get less as you're expected to live longer. You can also get annuities that continue to pay until both you and your spouse dies (called 'joint life', as opposed to 'single life').

You can get a 'level annuity', which is an income that remains the same till you die. You can also get annuities that increase by 3% per year, or annuities that increase each year in line with inflation (using the 'Retail Prices Index' - RPI). With both of these 'escalating annuities', you'll have to accept a lower starting amount.

On top of that, you can also shop around at different companies to see who is offering the best rate - known as the 'open market option'. 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%. In addition, if you smoke or have one of a range of medical conditions, you may also get a higher income by choosing what is known as an enhanced or impaired life annuity.

Plus you can choose a 'guarantee period', typically of five or ten years. This means it'll continue to pay the full income to a partner or to your estate if you die within that period. Opting for a guarantee period reduces the size of the annuity you can expect.

Factors that affect the size of your annuity

Factor	Affect
Shopping around	You can find better annuities if you compare annuity rates from several providers
The size of your retirement pot	If you have a bigger pot you get a larger annuity
Gender*	Men get better annuity rates than women
Smoking*	Smokers get better annuity rates
Age*	Older people get better annuity rates
Single-life versus joint-life annuities	Single-life annuities have better rates
Level versus escalating annuities	Level annuities start higher, but escalating annuities increase each year
Impaired and enhanced annuity	You get a better rate with these annuities

*If you get a joint-life annuity, the age and gender of your partner, and even whether they smoke, might affect the annuity too.

All told, choosing an annuity can be a decidedly tricky business and you only have one shot at it. Once you've bought an annuity you can't then go back and change your mind if you find a better deal. As your choice of annuity can dictate your income for the rest of your life, it's not a decision to take lightly!

Current annuity rates

Annuity rates are much lower than they have been in the past. In fact, they've roughly halved over the last 25 years. At the time of writing, to buy an annuity income of £10,000 a year that increases in line with inflation, a 65 year old man, who wants his wife to receive half of his pension if he dies before her, will require a pension pot of nearly £250,000.

Unsecured pensions

Many people have campaigned for the compulsory purchase of annuities to be removed and, to some extent, the government has listened. In April 2006, new pension legislation came into effect. Up until the age of 75 you have the option of either taking out an annuity or an 'unsecured pension'.

An unsecured pension is similar to the previous 'income drawdown' system where you draw an annual income while the remainder of your fund remains invested. You're able to take a minimum income of £1. The maximum you're allowed is 120% of a level single life annuity. (So if, with a single-life annuity, you'd get £1,000 per month, you're allowed to take up to £1,200 with unsecured income.)

Unsecured pensions are more risky, but unlike annuities you can pass on your remaining pension pot to dependants.

Alternatively secured pensions

After age 75 you can either go for an annuity or 'alternatively secured pension' (ASP). ASPs allow you to retain control of your pension pot, and take an income from it, in a similar way to unsecured pensions. On death the remaining funds can be used to provide a dependant's pension. If there is no dependant the fund can go to another member of the pension scheme or to charity.

Sadly, though, the government backtracked on ASPs to the extent that a huge part of the remaining funds - even the majority - is taken away in various taxes and charges before it is passed on. Also, there are restrictions on the income you can take from it.

Limited period annuities and value protected annuities

From April 2006, two new types of annuity are now allowed -- the 'limited period annuity' and the 'value protected annuity'. The former lasts for just five years, after which time you can buy another one, or a normal lifetime annuity. The latter will pay out any unused amount to your heirs, but you'll get a lower income than a normal annuity.

Although these changes will provide some welcome flexibility they also make a complex decision that much more difficult. As it's early days, just how well these new annuity rules will work in practice remains to be seen!

Annuity pros and cons

You've been saving in your pension fund all your life and, don't forget, the Government's been letting you do it before you pay tax. Now the Government wants its money, and it gets it back because you have to pay tax on the income you get from your annuity.

The Government, in fact all of us really, also don't want to see you blow all your cash on the bingo and end up living off the state. So it makes you buy an annuity with most of your pension fund and the idea is that that should keep you off the streets. An annuity is also a means by which you can ensure than your pension fund runs out exactly when you do. It doesn't matter if your retirement lasts 50 weeks or 50 years it'll keep paying out. But when you die, that's it. There is nothing left for you to pass on to your descendents. That's what annuities do -- they give certainty.

As always, though, there is a big price to pay for this certainty. In order to guarantee to pay you a particular amount for the rest of your days, the insurance company has to back up its promise to you with some very safe investments. In fact, your annuity is effectively backed by the safest investment of all -- gilts.

Herein lies the main drawback. Gilts are all very well for a short amount of time but over long periods of time, they have not offered a great rate or return. Annuities made more sense when retirements lasted for only a few years, but now people are living longer and longer in retirement. Thirty years is certainly not unusual these days and it's getting longer still. Investing for these sorts of period is the province of 'real assets' like shares and property. After all, with the inflation we've seen over the last 30-odd years, an annuity from the 1970s would now be looking decidedly inadequate.