An annuity uses your pension pot to buy a regular income for your retirement - if you choose this option, it’s important to shop around for the right deal.
If you have a private pension, it’s common to use some or all of it to buy an annuity.
An annuity provides you with a monthly or annual income for the rest of your life in exchange for a lump sum at the outset.
Since the pension freedoms introduced in April 2015, you no longer have to use three quarters of your pension to buy an annuity to live on for the rest of your life.
However, there are major tax implications associated with taking more than 25% of your pension as a lump sum in a single tax year, and other options are unlikely to offer the guarantees and security that can be afforded by annuities.
For these reasons and more, annuities remain a popular option for funding a retirement - find out more about the pros and cons, and the things you should consider.
However, you don’t have to take an annuity offered by your pension provider - you’re free to shop around and buy your annuity from any provider you like, and you may well find a more appropriate deal by doing just that.
While you can shop around for an annuity, it’s absolutely crucial to remember that you only get to choose it once and you can’t change your mind - so it’s vital you make the right decision.
With annuity products and fees varying widely between providers, going for the wrong option could cost you thousands of pounds.
“In 2012, around 60% of annuities were purchased from customers’ existing pension providers or through a third-party with which their provider had an arrangement,” said the Financial Conduct Authority (FCA) in a February 2014 study.†
However, according to the research, staying loyal to your pension provider when choosing an annuity doesn’t necessarily pay.
“80% of consumers who purchase their annuity from their existing provider could get a better deal on the open market,” said the FCA.
“On average we estimate that those who purchase a standard annuity from their existing pension provider could increase their income by £67 a year by purchasing an annuity on the open market.”
The FCA also found that, in some cases, this amount could be much greater and that most firms offered the same rate to existing customers and new customers – only two rewarded loyalty with better rates.
The type of annuity you choose will depend on your own circumstances, whether you have any dependants and your attitude to risk.
Depending on the size of your pension pot, you might want to speak to an independent financial adviser before making such an important decision.
A single-life annuity is the most basic form of annuity, where you simply receive an income until you die.
The payments cease upon your death, so it’s typically seen as most suitable for those with no financial dependant, or for an individual whose partner has their own pension arrangements.
The only exception to payments ceasing after death is if the annuity has a ‘with guarantee’ period.
This means that a single/double life with guarantee product would continue to pay out after the holder’s death if it was still within the guarantee period.
Just like a single-life annuity, a joint-life product provides you with an income for life.
However, when you die it transfers to your spouse, partner or chosen beneficiary and pays them an income for the rest of their life.
Alternatively, it can be used to pay an income to a dependant child, but this usually ends when they’re 23 rather than upon their death.
A joint-life annuity might be suitable if your spouse or partner doesn’t have their own pension arrangements, or if their own pension payments will be too low.
When you die, the income paid to your nominee will be a percentage of the income you were receiving from your annuity just before your death.
You choose this percentage when you buy your annuity - for example 100%, or 50%.
The higher the percentage you choose, the lower your own retirement income will be from the annuity.
If your spouse or partner is a lot younger than you - for instance more than 10 years younger - annuity providers may not agree to set up a joint-life annuity.
Whether you opt for a single-life or joint-life annuity, you also have the option of choosing an escalating product where, rather than payments being fixed for life, they increase over time.
This means the value of your income is less likely to be eroded by the effects of inflation.
An enhanced annuity is an option for people with a medical condition or unhealthy lifestyle traits, such as smoking or being overweight.
To put it bluntly, because the provider doesn’t expect you to live as long, it may pay out higher - or enhanced - payments.
If you’re on any prescription medicine, it’s worth checking whether you qualify for an enhanced annuity.
With some providers you may even qualify for things like having worked in jobs involving a lot of manual labour, or living in a particular area.
Investment-linked annuities offer an income based on the performance of investments.
A with-profits annuity provides an income that’s linked to the performance of an investment fund managed by the annuity provider.
Alternatively, you can take a more hands-on approach with a unit-linked annuity where your income is linked to funds you choose to invest in.
Investment-linked annuities all have a set minimum that your annuity income won’t fall below, but you should make sure this will be enough for you to live on if the worst happens and the investment performs poorly.
The important thing to remember with an investment-linked annuity is that your income could fall as well as rise.
You don’t need to buy an annuity immediately upon retirement and the later you leave it, the higher the annuity income your provider will offer you.
For instance, it might offer a 60-year-old a £6,000 annuity, but to a 70-year-old it might offer £7,000.
Annuity income won’t just be decided based on your age though - your provider will also take into account your health, lifestyle, postcode and other factors when calculating what it will offer you.
Since the pension reforms in April 2015, it’s not compulsory to convert your pension to an annuity.
This means you’re free to take money out as a regular income or lump sum(s), which is known as income drawdown.
You can just spend such money as and when you need it, or you may choose to invest it somewhere in the hope that the returns will pay you a regular income.
According to the FCA: “In 2012, 420,000 annuities were sold - 16 times more than income drawdown products with a value of £14bn compared with £1.2bn for income drawdown.”
Despite their past popularity, in the wake of the 2015 pension freedoms, the number of people taking annuities is expected to fall.
The thing to be aware of if you don’t take out an annuity is that there’s no guaranteed income for life - in other words, your money could run out before you die.
There may also be major income tax implications if you draw down more than 25% of your pension in a tax year.
Don’t forget to consider all the options for your retirement, such as investments or bolstering your pension with additional savings.