What are annuities and should I buy one when I retire?

annuity.jpegIf you are approaching retirement age then you will no doubt soon be thinking about your own pension arrangements. If you have not had the good fortune of being a member of a defined benefits pension scheme (the technical name for a final salary pension) then you will have to decide yourself about how best to convert your pension pot into an income in retirement. You may take some comfort from the fact that you are not alone in this predicament due to the number of companies who have closed their final salary schemes over the past twenty years.

So for those in the position of having to make their own pension arrangements, the most popular option is to convert their pension pot into an annuity. Although the concept of an annuity is a pretty straightforward one, the topic for most of us is shrouded in mystery. In fact recent research from one leading annuity provider found 71% of those questioned only had a ‘vague understanding’ of what an annuity was. As an annuity is only ever purchased once when someone is about to retire, it is rarely brought into consideration before this time. It is therefore perhaps to be expected that there exists a lack of understanding over what annuities are. In layman’s terms an annuity is essentially a form of insurance whereby you ‘sell’ your pension pot to an annuity provider who then in turn guarantees to pay you an annual income for the rest of your retirement (regardless of how long that is). When you make an annuity purchase, you can normally take up to 25% of your pension pot tax-free, with the rest being paid out in annual income for the remainder of your retirement. The amount of income you receive will depend on the annuity rate being offered by a provider. One important point to note here is that not all providers offer the same annuity rates, or indeed the same annuity products (of which there are many). For this reason it is absolutely essential that you seek proper advice as well as comparing providers before you make an annuity purchase. Just by undertaking this comparison process you could see an immediate increase of up to 20% on your initial offer from your current pension provider.

If you have a health problem or medical condition (past or present) then it is especially important that you compare providers as you may qualify for an enhanced annuity. These types of annuity offer a higher income level because the provider assumes the individual will live for a shorter time period compared to someone who is fit and healthy. However because not all providers offer enhanced annuities, you must shop around to see who has the best rates. An enhanced annuity can be worth as much as 40% or more compared to an initial offer from in incumbent provider so it is extremely important to check to see if you are eligible. It is thought that around two thirds of all those who buy an annuity are indeed eligible for some form of enhancement, despite only a fraction of those actually receiving an enhanced offer.

In addition to comparing providers, it is also important to seek advice about what kind of annuity will be best suited to your own personal circumstances. The default offer from your current provider is likely to be a standard annuity sold on a single-life basis that will pay a fixed and equal amount of income for life. Although this type of annuity has the highest starting amount, it does not take into account the impact of inflation, offers no means of increasing your income in the future and will not provide an income for your partner or spouse should you pass away before they do. This considered, you may wish to consider hiring the services of an Independent Financial Advisor or alternatively speaking to an online annuity broker who will be able to offer advice about the different options available to you in retirement. One point to note is that an annuity is not the only choice available for someone who has paid into a defined contributions pension scheme. There exist several alternatives to buying an annuity, including income drawdown, temporary annuities as well as delaying a life annuity purchase. Knowing which choice best suits your circumstances will require detailed discussion with an adviser who can talk you through the advantages and disadvantages of each option.

Author Information: Simon is the owner of the annuity comparison website 123AnnuityRates where you can find further information about the topics discussed above.