Five questions you should ask before buying an annuity
For people retiring 20 years ago, there were few options when reaching retirement. The alternatives extended to perhaps two or three annuity options.
Although income drawdown was in its infancy, it was not widely publicised or used at the time, possibly due to the more attractive returns offered by annuities.
Fast forward to now and the situation has nearly reversed, with flexi-access drawdown almost a default choice. In addition, with many articles praising the benefits of drawdown over annuities, individuals could be forgiven for overlooking annuities altogether.
However, an underlying fact of drawdown is that you must understand and accept that you are taking on the risk of your money running out before you die because the length of your life and the investment returns are variable and outside of your control.
If these risk factors can’t be understood and accepted, an annuity could be right for at least some of the funds available from pension plans.
So what factors should you take into account when considering an annuity?
1) How much secure income do you need?
Is it just enough to cover your basic monthly outgoings or would you prefer your whole income to be certain and for the remainder of your life? One of the factors of income drawdown is that any funds remaining in the pension on death can be passed to loved ones. Do your income needs outweigh the wish to pass on any remaining capital on your death?
2) What degree of guarantee should you build in?
An annuity will pay an income for life, but ceases on death. It is possible to buy a guaranteed minimum income so that in the event of early death following purchase, the annuity would continue for a minimum period. Although this feature reduces the initial starting level of income, it may provide peace of mind if you’re worried about unexpected early death.
3) Should you include a spouse’s pension?
A pension need not stop totally on the death of the annuitant. Often it can continue to a surviving spouse at a reduced rate for the remainder of their life. This feature will also have a cost and could reduce the members starting level of pension. Consider this if your spouse might be expected to outlive you.
4) Should an annuity be level or escalating?
Your pension capital will buy a higher starting pension if it is level in payment but be careful as inflation could erode the value of the pension significantly over the remainder of your lifetime. An escalating annuity is one which increases each year, usually at a fixed rate being perhaps 3% or inflation.
5) Your health and that of your spouse
Annuities work by pooling expected mortality, where those who die early cross-subsidise those who live longer. However, if you have a known health condition or even a lifestyle that may lead an annuity provider to believe your lifetime might be impaired, they may apply special rates enhancing your annuity income in view of the perceived shorter period that it will be payable.
Most importantly, you should shop around or take advice from a regulated financial adviser. There are far fewer annuity providers than there were but still enough of a market to seek out the best deal.
Martin Tilley is director of technical services at Dentons Pension Management