FOOL SCHOOL
Annuities

September 22, 2003

The government -- and you won't be surprised to hear this -- doesn't trust you a great deal. It doesn't trust you not to blow the entire amount of your retirement fund on a rank outsider in the 3.30 at Kempton Park or a two-week orgy of high living in a pink Rolls-Royce with personalised number plate 'FOOL 1'.

If they did trust you not to do any of these things and you let them down, then they would end up having to feed and house you and that's why they make you buy an annuity with the money you have accrued in your pension. It's a very sensible decision on their part, they see it as just return for their generosity in giving you tax relief on your pension contributions for all those years, and it lets them avoid what could potentially be a whole lot of bother. For you, though, it may not be so good. Let's see why.

An annuity is the way in which you convert the money you have built up into a regular income to see you through your retirement. It works broadly like this:

1. You retire.
   
   
2. You take the dosh in your personal pension, AVC or Defined Contribution occupational pension fund and use it to purchase an annuity, either from the company with which you already have your policy, or another company (for the privilege of which you may be charged a penalty by your original company).
   
   
3. The annuity pays you a fixed income until you die. The precise amount depends on how long they think you have left to live. Women, who live longer than men, receive less than men of the same age. Older people receive more than younger people. Students of the macabre will note that with some companies, fat smokers can negotiate larger payments than slim non-smokers (these are known as impaired life annuities).
   
   
4. The amount you receive does not increase with inflation, unless you have agreed to accept a substantially reduced initial annuity income.
   
   
5. Your spouse may get nothing when you die, unless, again, you have agreed to accept a substantially reduced initial annuity income.
   
   
6. Finally, you and your spouse both die. BIFF! When you and your spouse are both dead, the annuity company keeps the money. Your relatives or favourite charity get nothing.

One of the problems with annuities is that these days we are living too long for them, and the rate of inflation is just that little bit too high to make them last. So, because annuity payments have to be stretched over an increased number of years, their rates have been falling. 

With the basic annuity, an insurance company effectively takes your money and uses it to buy some gilts. It buys gilts because it needs something that is considered to be low risk and that provides an income. But people reading this may be looking at twenty, thirty or even more years of retirement. And gilts are often not a great investment over that sort of period and falling interest rates on gilts in recent years are another reason why annuities rates have been coming down. However, if you've built up a big enough pension pot, then at least you can buy the security of an inflation-proofed income or a guaranteed period annuity.

It's important to make sure you shop around for the best deal. You don't have to buy your annuity from the same company that provided you with a pension, and there can be significant differences between what each company offers for exactly the same product.

You can find out more about annuities and current annuity rates at sites like the Annuity Bureau and William Burrows. Also check out the Fool's pension centre and our Annuities discussion board.