FOOL'S EYE VIEW
How to Choose an Annuity

By Rob Davies
May 22, 2001

Colchester, Essex -- Some of the most vigorous discussions on the Motley Fool are about annuities. An annuity, just in case you had forgotten, is a stream of income that you buy on retirement with the money in your personal pension plan. There are two choices to be made: the type of annuity that best suits your needs, and which provider to buy it from. This article will focus on the first choice -- once you have decided what type of annuity you need, you can shop around for the provider that offers the best deal. Every provider will have a slightly different estimate of how long you're going to live, and hence how much of the pot to pay out each year.

The first point, and the most crucial one, to understand about annuities is that although there are many different types -- joint life, single life, inflation-proofed and so on -- on the day you buy the annuity the size of your pension pot is fixed. The difference between the types of annuity is how that pot of money is paid out to you.

Once we realise that an annuity is simply one pot of money that can be distributed in many different ways the differences between each type become easier to understand. For example, one of the biggest differences is that between annuities for men and for women. On average, women live longer than men, so their pot must be spread out over more years and, as a result, the income for each individual year will be lower for the female than for the male.

For example, a couple who will be relying on an annuity bought with the male partner's pension have a choice. They can buy a single life annuity for the man, which will pay out more each year but will cease paying out on his death; or they can buy a joint life annuity, which will continue paying out until the death of the last partner. Because (on average) women live longer than men, the joint life annuity is expected to pay out for longer and will therefore pay less in each year -- the same pot is being spread over a longer period.

In the same way, seeking to protect the annuity from inflation means a redistribution of the payout. An inflation-proofed annuity will pay out progressively more money over time. So in the early years it pays less than a standard annuity, but pays more than standard in the later years. Again, the total amount will be the same, assuming all other things are equal.

To provide a reasonable income in retirement from an annuity you need about £200,000, in today's money, on the day you retire. Depending on age that will give an annual income of something like £15,000. It is possible to buy an annuity at any point from the age of 50 to 75, when it becomes mandatory. Buying it early, when you have a long life expectancy, will obviously give a lower annual income than buying it later, when your life expectancy is lower. But remember that every year you don't benefit is a year of lost income.

Annuity income is partly a return of the capital you have built up in the pension, and partly interest generated from the gilts (Government bonds) that the annuity is usually invested in. That worked well when life expectancy at retirement was only a few years. However, now that a sixty-year-old can expect to live for another 20 years the story is a little different. Inflation needs to be considered, even if it isn't a problem now. An inflation rate of only 2.3% a year reduces the value of £1,000 to £776 in ten years.

Moreover, choosing to depend on gilts for a significant part of your income -- which annuities do -- might not be a good idea if real returns significantly outpace nominal returns. All the historical evidence shows that equities are the best place for investments on a time horizon of ten years or more. And these days some people are retiring at fifty, giving a retirement that might last for thirty years.

So one option to be considered is an annuity that is invested in equities rather than bonds, called a unit-linked annuity. A similar product is a with-profit annuity, where the money is invested in the with-profit fund of an insurance company. In this case the income will vary with the level of bonuses declared by the manager. Given the problems that some of these are facing, that may be a risky route. A slightly safer alternative is a guaranteed with-profit annuity. The income may still vary, but there is a low guaranteed income to form a base. Higher risk, but probably more rewarding, are self-invested unit linked annuities where you choose what the fund invests in.

In annuities, probably more than anywhere else, the phrase "You get what you pay for" is the most relevant one.

Finally, we need to mention that you don't have to purchase an annuity as soon as you retire. It is possible to use a plan, called income drawdown, in which you take income from the pension fund, but without actually buying an annuity until legally obliged to at age 75. The attraction is that the fund can continue growing for the maximum time possible, and should you die in that period, the remainder of the fund can be passed to your beneficiaries free of Inheritance Tax. Of course a standard annuity stops when the recipient dies, so it is not good at all for passing wealth from one generation to the next.

More: Fool's Guide to Annuities
The Annuity Bureau