Making the Most of Your Annuity

How to choose your annuity

Exchanging your pension pot for an annuity is probably the largest financial decision you will ever make, larger even than buying a home. When you are buying a home, there is always the possibility that you will be able to sell it at a later date, and alter your living accommodation to suit your changing needs. You can move to a new location, even a new country, or enhance your home by adding extensions, redecorating, or remodelling. In fact, you will probably do all of these through your life.

But when purchasing an annuity, the decision you make now has to hold good for the whole of the annuity term, which could be for life. It’s important to be really focused, not just on what your needs are now, but what they may be in the future.

Question to ask yourself

In coming to the right annuity for you, there are some questions that you should ask yourself.

Are you single or married?

If you are single with no dependents, then a single life annuity will be perfectly adequate. You don’t have a spouse to worry about should you die, and a single life annuity will offer a better level of income than a joint life annuity.

However, if you are married, then a joint life annuity will give you the peace of mind that your loved one will receive an income should you die first.

Do you want to know the amount of income you will receive through to your death?

A lifetime annuity will pay an income through to the time you depart this world. A fixed term annuity, on the other hand, will give the flexibility to alter your income arrangements at a fixed time in the future. However, the maturity amount on a fixed term annuity may not buy you the same income as you could get by buying a lifetime annuity now.

Do you want to know that your income will be paid for a minimum period of time?

A guaranteed annuity will pay income payments over a minimum period, say 5 or 10 years. This type of policy guarantees payments to your named beneficiary through to the end of the guarantee period should you die. Such a guaranteed is a cheap way to preserve death benefits for your loved one.

Are you prepared to take risk with your income?

An investment based annuity gives the potential of return on an underlying investment fund, which could boost income through the life of the annuity. However, it should be remembered that investments can go down as well as up and adversely affect your investment and income.

What is your state of health?

If you are suffering from a terminal illness, or other life threatening condition, your income can be greatly enhanced by purchasing an enhanced annuity (also called an impaired annuity). The life company will assess the likely length of your life, and base your income level on this. £100,000 invested for income over a potential lifetime of ten years will pay a lot more income than £100,000 invested when the life expectancy is 20 years.

Are you concerned about the effects of inflation?

Inflation will decrease the spending power of you income over time. If inflation is a constant 4%, then over an 18 year period the value of your income will halve. Taking an income that increases over time can help fight against the effects of inflation. However, the downside to an escalating annuity is that the initial income will be far lower than an annuity that pays level income throughout its term. An annuity that escalates by 3% per year purchased by a 65 year old man will give an initial payment of 25% less than a non-escalating annuity, and take 20 years to repay the same amount.

Where to buy your annuity

Most pension schemes allow you to buy your annuity from the whole market, a so called open market option. This means that you can compare rates payable from all firms that offer the type of annuity that best suits you at the time you want to purchase your annuity.

Your options to mix and match

Having answered all the questions above, you will need to source an appropriate annuity. It is very unlikely that a standard annuity will be sufficient for your needs. So, you can mix and match the different conditions attached to annuity to work through to the best annuity for you.

Example

You may decide that you want to be assured of your income throughout the remainder of your life. So a lifetime annuity is the best base type to purchase. On top of this, though, it may be that you are worried about the risk of inflation to your lifestyle through your retirement. So an escalating annuity that increases income throughout the payment period will suit this need.

You may also want to ensure that your spouse has an income should you die, and so you need a joint life annuity.

At this stage you now require a joint life, escalating lifetime annuity.

Your options for an annuity will be reduced, but now you can conduct a more focused search amongst the companies that offer such policies and select the one that offers the best annuity rate.

A final word about escalating policies

Dependent upon the rate of escalation, the state of your health, and other conditions attached to your annuity, an escalating policy will begin with a far lower starting income than a level annuity. For a 65 year old man wanting an escalation rate of 3%, this starting income will be around 25% lower than that for a level annuity.

For a disciplined individual, a different strategy to enhance annuity income through lifetime is to self-discount income by a corresponding amount of the discount to that which would have been received under an escalating annuity. This cash can then be saved or invested as tax efficiently as possible (for example in Cash Isas or Stocks and Shares ISAs) and released at a later date when needed. A new lump sum can be built up in this way, either to create an inheritance or for use in later life.

In conclusion

Whatever your selections as to annuity requirements, a purchase is not a choice that can be made in just a few minutes. Understanding the different types of annuity and how they work is a start, but understanding your requirements now and in the future is the key to making the right decision for you. This takes meeting with a trusted financial advisor and then discussion with others that may be affected, such as your spouse.