Annuities explained Annuity options
When you buy a pension annuity, you exchange a lump sum for an income payable for the rest of your life. However, the type of income you decide to have will make a big difference to the amount you receive.
The main factors to consider are:
- whether you want protection against inflation during retirement
- how much risk you are prepared to take
- whether anyone else is dependent on you
- how much flexibility you need to change your pension after it has started to be paid
- how much control you want over your investments
- what charges you will need to pay
- whether you want to provide an inheritance for your survivors
- what your general state of health is and whether you are or have been a smoker.
Level or increasing annuity?
You'll need to decide whether or not you want your income to increase each year. You can buy an annuity that increases with inflation, or one that's set to rise by a fixed percentage each year. Alternatively, opt for a level annuity, which will provide exactly the same income each year.
Level annuities are the most popular type, probably because they offer the highest starting income, but they do leave you vulnerable to inflation. Remember that a 4% rate of annual inflation will halve the buying power of an annuity in 18 years.
However, if you buy an annuity with protection against inflation, you'll have to accept a lower starting income. Although your income increases over time, it might be many years before it catches up with a level annuity.
You probably need to think about your plans for retirement before deciding whether or not you want an increasing annuity. Do you want to maximise your income during the early, healthiest years of your retirement, or do you want equal purchasing power over the years?
Your answers may depend on your health and how long you expect to live. If you have an existing medical condition, you may be able to get an even higher rate with an enhanced annuity (see the enhanced annuities section).
An annuity with an annual 3% escalation could reduce a 65-year-old man's initial pension by around 25%. He would need to survive for around 20 years to make this option better value than the equivalent level pension.
Single or joint life annuity?
The next decision is whether you want an annuity that covers you alone, or one that protects your partner as well should you die first, often known as a survivor's pension.
A single life annuity pays you an income until you die, but if you're part of a couple and die first, this could mean that your partner is left short of money. A joint life annuity continues to pay some or all of the annuity income to your partner when you die. A joint life annuity will typically pay around 50% to 67% of your annuity income to your partner after your death.
There are, of course, some trade-offs for this extra provision. Because a joint life annuity will continue to be paid after you're dead, the rates offered are lower. The higher the proportion of your annuity income that you choose to be paid after your death, the lower the initial income paid by your policy.
And if your partner is younger than you, the insurance company will offer a lower annuity rate, as they expect to be paying out for longer.
Where an annuity has a guarantee period, it will be paid out for a set time period, usually five or 10 years, even if you die during that time. If you do die during the guarantee period, the payments may continue as an income to your survivor(s) for the remainder of the period, or can sometimes be rolled into a lump sum.
An annuity with a guarantee is sometimes seen as a substitute for a joint life annuity. But it's not the same, as the maximum guarantee period is only 10 years. As a result, it won't fully protect your dependants in the long term.
For more advice on pensions, see our book Pensions Explained, which covers state, personal and company pension funds.