Which annuity is right for me?
Andrew Tully, pensions technical director at MGM Advantage, guides us through the different types of annuity products on the market.
Many people think of annuities as a complex area and one they would choose to avoid if they could. However, an annuity is a relatively simple concept when you think all it does is provide an insurance policy for your retirement.
You give your pension savings to the annuity company in return for a guarantee that they will pay you the income agreed for the rest of your life (and that of your spouse or wife if you choose that option).
The tricky bit comes when you are faced with key decisions about the choices you need to make when buying an annuity. Should I go for the highest starting income? Should I protect my wife or spouse? Should the income be protected from inflation? Do I need to buy an annuity at all?
All annuities convert your pension into a retirement income for life, in exchange for that pot of money. The decisions you make at retirement when it comes to an annuity are usually irreversible.
The most straightforward annuity is the conventional or level annuity. These provide an income on a monthly or annual basis. The income from the annuity will remain in payment until you die, unless you had decided some or all of that income would continue to your partner when you die.
Enhanced annuities are a development of the conventional annuity, which are aimed at people who have health or lifestyle conditions. These annuities typically pay a higher income than a conventional annuity as the provider is calculating that, on average, you will not live as long as someone of comparable age who is in good health. Common conditions which qualify for enhanced annuities include diabetes, high blood pressure, high cholesterol, smoking and people with a high BMI. Our research shows up to 70% of people could qualify for enhanced terms.
Annuity with escalation benefits
If you are concerned about the rising cost of living, then you can protect your income by using an annuity with escalation benefits. This essentially means you choose at the outset how your income will increase every year, usually by 3% or the retail price index (RPI). The benefit here is your income should keep up with the cost of living. The downside is the starting income is usually significantly less than the conventional level option.
Fixed-term annuities are relatively new and basically do what they say on the tin. For a fixed-term, usually five years, the provider will provide a guaranteed income. Once the five years is up, you can decide what to do with the pension pot you have left. Fixed-term annuities may appeal to people who want some flexibility, or think annuity rates will improve over the course of the fixed-term. Of course, annuity rates are a subject on their own, but you are taking a gamble on rates improving to make this potentially viable.
The final piece of the annuity jigsaw is investment-linked annuities. These annuities provide a flexible income, which can be varied by you within certain limits. They can also take your health and lifestyle into account when determining the income you can get. Your pension pot is invested in the stock market. This means your fund has the potential to grow over time while also providing some protection against inflation. If your pension pot grows over time, you can increase the level of income you can take. Given a typical retirement of 25 years, history shows us that even when times have been very tough (2008 and 2009 spring to mind), stock markets bounce back and provide positive returns.
Over the page: how to decide which annuity is right for you…
So, given the myriad of annuity options available, which one is the right one for you?
Firstly, never take it on face value that the initial annuity offer made to you by your existing pension provider is the best you are going to get. You have the right to shop around for not only the best annuity rate but also the right shape of income for your individual circumstances. It could make a 40% difference in the income you will receive.
Always tell the provider about your personal health and lifestyle. The questions might seem very personal, but all are designed to make sure you get the highest income available at the point you retire.
Consider how you will manage when inflation begins to erode the purchasing power of you pension income. And always consider the impact of your death on your wife or spouse. How will they manage if your pension income suddenly stops?
You can also ‘pick and mix’ options, for example using some of your available pot to secure a fixed income and use the balance to invest in an investment-linked option to mitigate the risk of inflation.
If you are unsure about any aspect of the annuity purchase, then seeking professional financial advice will ensure you choose the right options when you retire. It might just be the best financial decision you will ever make.