Buying an annuity
There are a bewildering range of different annuity types on the market and you only get one chance to make your selection, so it is crucial that you receive professional advice before you buy.
The "annuity rate" expresses the annual income your annuity will provide as a proportion of the lump sum you invest. If the annuity produces a rising income, the quoted rate indicates the income at the start.
The annuity rate that you receive is dramatically affected by whether you wish the amount of income to remain the same or increase each year and whether you wish an income to continue to your spouse or dependents after your death. Rates also vary between companies and change regularly and you won't be able to change your mind once you've bought your annuity, so it is vital to shop around as buying an annuity is one of the most important purchases you will ever make.
The vast majority of pensioners simply opt for a standard or conventional annuity. Here the level of income you get depends on a number of factors, including gender (women receive commensurately less because their average life expectancy is longer); age (the older you are, the more you get because you are expected to die sooner); and prevailing economic conditions.
Increasing life expectancy and low inflation over the past few years have caused annuity rates to fall. Other choices include whether to buy a level annuity, which pays the same income for life or an escalating annuity, which increases by a set percentage each year.
It is possible to buy an annuity that increases each year in line with inflation. Normally they are linked to the retail price index (RPI), but you can choose how much you want your income to rise annually, for instance by 3 per cent or 5 per cent. In return for this, however, the initial income may be cut by at least a third. How well RPI-linked annuities perform compared with level annuities depends on what happens to inflation.
Enhanced annuities are for people with unhealthy lifestyles, such as smokers, or with health problems, such as asthma or more serious medical conditions such as Alzheimer's, cancer or coronary disease and may be as much as 20 per cent greater than standard annuities.
Smokers, for example, might receive 7 to 8 per cent more than they would from a standard annuity. If they are also a diabetic, their booster could rise to 12 per cent, and higher still if they have high cholesterol.
Enhanced annuities, including "impaired life" and "lifestyle" annuities, offer a higher income because life expectancy is expected to be substantially shorter than average and therefore the total paid out by the annuity provider will be less. You do not have to be seriously ill to qualify, but you will still receive more than from a standard annuity. In short, the worse your health, the more you get.
Investment linked annuities offer you the chance to select your own income at outset, on the basis that this may vary in future dependent upon investment returns. They offer the potential to boost the income provided by smaller pension pots but you need to be aware that income levels will fluctuate and possibly reduce as a result of investment conditions.
These fall into two camps: with-profits annuities and unit-linked annuities.
With a with-profit annuity you choose an income level, which assumes the addition of bonus rates to maintain it. Whenever a future bonus is added, a calculation is made and if it is higher than assumed at outset, the annuity will increase. On the other hand, if the bonus is less than predicted, the annuity may fall. Some with profit annuities may offer a guaranteed level below which income will not fall.
Unit-linked annuities work in the same way except that the level of income depends on the performance of the funds they are linked to, such as managed funds. This will go up or down depending on the actual investment returns.
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