What is an Annuity?

An annuity is a sum of money paid out in regular installments in return for the investment of a lump sum, such as a pension fund.

If you have a personal pension or are a member of an occupational pension scheme, you will contribute to a pension fund over the course of your career. When you retire, the money in your pension fund needs to be turned into a regular income. An annuity is one option.

If you buy a lifetime annuity, the income will be paid for the rest of your life. If you were to die soon after buying the annuity, you would have ‘wasted’ most of your money. If, on the other hand, you lived to a 100, your annuity would still provide you with an income long after your savings might otherwise have run out. Annuities work much like insurance in this respect.

How Much Income Might you get?

The income you will get from your annuity in your retirement will partly depend on how long the provider expects to have to pay out the income. The provider will look at your circumstances and will calculate how long people like you generally live and base its calculations on this. The longer you are likely to live, the lower your monthly income will be.

If, for example, you retired at 60, and could expect to live for another 20 years, you will receive a lower monthly income than if you retired at 70 and could only expect to live for another 10 years.

If you have a serious health condition or are a smoker, you might be able to buy an ‘enhanced annuity’ or an ‘impaired life annuity’ and receive a higher income as your life expectancy will be lower than a healthy person’s.

Historically, the level of income will also varied depending on your gender as women tend to outlive men. A woman’s income from an annuity has so far been lower than a man’s of the same age and in the same state of health as a woman tended to live longer than a man.

‘it is no longer compulsory for a pensioner to purchase an annuity’

Due to equality legislation, since 21st December 2012, the income is the same for both men and women, meaning that women are likely to get a bigger income while men will get a smaller income.

The amount of income you get also depends on investment conditions at the time you buy the annuity. This is because the provider invests the lump sum that you pay for the annuity.

The bigger the return on the provider’s investment, the higher the income it can pay you.

The money is typically invested in bonds, so annuity rates tend to go up and down with the return on gilts and corporate bonds; with interests remaining at historically low levels, rates available from an annuity may not appear attractive, although the rates they do offer come with a higher degree of certainty than some other options.

Choices at Retirement

The basic principles explained above apply to all annuities. But there are many different types of annuity. For example, some pay an income that increases each year and some aim to protect you from losing out if you die soon after buying the annuity. So choosing an annuity means matching the type of annuity to your own particular needs and circumstances.

‘Choosing the right annuity also means shopping around for the best deal’

Choosing the right annuity also means shopping around for the best deal because the amount of income you are offered varies from one provider to another. It is especially important to shop around if you might qualify for an enhanced annuity or impaired life annuity – you will lose out if you accept the income offered to an average person.

Since the pension freedoms announced in 2014 it is no longer compulsory for a pensioner to purchase an annuity.

Whatever the long term plan, the option exists for those reaching 55 to take 25% of the value of their pension fund tax free and they can then buy an annuity, remain invested and go into income drawdown, or take personal control of their pot and seek to achieve an income in retirement by judiciously investing their savings.