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If you have any form of personal or money purchase pension you will need to buy an annuity by the time you are age 75.
What is an annuity?
An annuity is an income paid to you for life by an insurance company in return for your pension pot. Once you have bought an annuity, you cannot usually change your mind and switch to a different one at a later stage.
Nor can you get your money back if you die the day after buying one, because annuities work by a system of cross subsidy. Those who die early subsidise those who live to a ripe old age.
What's the point of annuities?
The beauty of annuities is that they pay an income for life - no matter how long you live.
However, annuity rates are currently historically poor, thanks to a combination of low interest rates, unimpressive stock market investment returns and greater life expectancy.
A £100,000 pension fund today will provide roughly 60 percent of what you could have received a decade ago for the same fund.
The annuity market is highly competitive and you can improve on the income offered by your pension provider by up to 30 percent by shopping around on the open market.
How do I go about this?
Inform your pension provider that you want to use the "open market option"(OMO). You can then go to an annuity specialist who will seek out the best rate for the type of annuity you require.
Before shopping around for the best rates, remember to check your pension does not incorporate a "guaranteed annuity rate" which other insurers are unlikely to be able to beat.
Types of annuity
The most commonly bought annuity is the "level payment" or "conventional" annuity. This will pay you the same amount of money each year for life.
If you desire increasing payments, you can take out an escalating annuity. This will increase every year by any percentage you choose, up to a maximum of 8.5 percent - but you will have to accept lower initial payments compared to that payable by level annuities.
An index-linked annuity also pays a lower initial income, but is guaranteed to rise in line with price inflation each year. Although inflation is currently low, it is worth remembering that inflation soared to 25 percent in the 1970s.
Impaired life polcies
If you have a life-threatening medical condition, smoke or are obese, insurance companies offer better rates via "impaired life" annuities because you have a shorter life expectancy than a healthy annuitant.
With-profits
More risky, but offering some prospect of growth over the long term, are with profit annuities.
These invest your pension fund in the with-profits fund of the annuity provider. However, your income will fluctuate and could even fall, so this option is best for those with other sources of income to fall back on.
Unit-linked
Unit-linked annuities are even riskier as they invest in unit-linked funds, meaning your income could be highly volatile. You should take advice on both with-profit and unit-linked annuities as they carry higher risk as well as the opportunity for higher returns.
Check out our Annuity Best Buy Guide
Thinking about your retirement? See if we can help. 20% off annual management charge when you arrange your Stakeholder pension online. Scottish Widows.
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