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What is an annuity?

What is an annuity?
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If you are nearing retirement, then choosing an annuity is a possible option. If you are unsure about annuity rates, then read on to find out more.

What are annuities and annuity rates?

An annuity is a financial retirement product that you purchase with your pension. It will pay you a regular income for a set period.

In terms of the period, there are two basic types:

  • A fixed-term annuity that will pay an income for a designated period
  • A lifetime annuity that will pay an income for life

Before 2015, people with defined contribution pensions had to use them to buy annuities once they reached retirement age. Following a change in the rules, you can access your pension from age 55 with no obligation to buy an annuity.

You may have to pay income tax on the income you receive from an annuity. This will depend on any other income you receive in a given year.

The amount of income received from an annuity is calculated as a proportion of the pension pot used to buy it. The proportion is expressed in percentage terms known as an annuity rate.

So, let’s say you use £100,000 of your pension pot to buy an annuity. An annuity rate of 2% will give you an income of £2,000 per year.

What are the advantages and disadvantages?

The main advantage of an annuity is that your income is guaranteed for the agreed time period.

As of April 2015, you can buy what are known as joint-life, value-protected or guaranteed annuities. If you have one of these products and you die before the age of 75, the annuity will pay your partner or beneficiaries for the remainder of the agreed period.

One of the main disadvantages of an annuity is the lack of flexibility. Once you purchase an annuity, you cannot change your mind, even if your circumstances change.

Annuity rates depend on a number of factors, including the economy. If you purchase an annuity during a downturn, you will not benefit from increased annuity rates if the economy picks up later on.

What is considered when annuity rates are calculated?

The income you receive from your annuity will depend on a number of factors.

1. Size of pension pot used

This is the amount of money used to purchase the annuity. The larger the amount, the larger the income.

2. Health and wellbeing

Someone that is expected to live a long, healthy life will be paid more over a longer period of time. As a result, their annuity rate will be lower than that of someone of similar age but in poor health.

3. Age at starting the annuity

This works on a similar principle. Someone older is statistically expected to have less time to live than someone younger. This will be reflected in the annuity rate.

4. Interest rates

Companies operating annuities obtain part of their income from investing your pension in the stock market. Therefore, when interest rates are low, annuity rates are also low.

Are annuities popular?

Annuities have fallen out of favour for various reasons. Pension changes in recent years have included the launch of pension drawdown, which allows people greater access to and control over their pensions.

Pension drawdown is viewed by many as a more flexible option in a fast-changing modern world.

For many, this is a far more attractive option than handing over hard-earned cash to an insurance company.

So, are annuities and annuity rates a waste of time?

No, they are not. As of 2015, you don’t have to use all of your pension to buy an annuity. So they can be useful as part of a blended approach.

You can draw down part of your pension and use it to buy an annuity with a rate that pays your essential bills. This will give you peace of mind that the essentials will be taken care of.

You can then use the rest of your pension in several different ways depending on your situation. This could be for an emergency fund, for debt repayment or to help your children.

A blended approach allows you to have the best of both worlds. You can have a guaranteed income for the essentials, and another source of income for any other financial outgoings.

Also, you won’t have to make a decision as soon as you retire. If you think the annuity rates are too low, you can wait before making a purchase.

Take home

If you can, think about your retirement in advance. Make some decisions about your lifestyle and expenses once you stop working.

If you are thinking about buying an annuity, it is worth seeking professional advice about your personal situation.

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