What is an Annuity?

If you want a reliable source of retirement income, read on…

Annuities can provide you with a guaranteed income payable for either the rest of your life or a fixed number of years. If you have a defined contribution pension scheme, you have several choices when you decide to start drawing retirement benefits. One of these is to buy an annuity to provide you with a guaranteed income, either for the rest of your life (a lifetime annuity) or a fixed number of years (a temporary annuity).

With falling interest rates in recent years, annuities have started to fall out of favour amongst retirees, as they seek to improve the returns on the money they have saved over a lifetime. As interest rates fall, then so does the income that the annuity providers are willing to pay out for their products, so a low-interest rate environment like we have right now might not be the best time to consider taking out an annuity product. However, for some people, they still provide a useful form of earnings, but only in addition to other types of retirement income.

Let’s take a look at an example of the returns a current low-rate annuity will provide in today’s money. A 60-year-old buying a level, single life policy with no guarantees for £100,000, would receive only £4,751 a year for life. Add into the plan a five-year guarantee, giving a partial refund if you die, as well as inflation-proofing so that your income rises in line with the retail prices index, and the annual payments reduce to £2,623 a year. Considering the average Briton only has a total wealth level of £265,000 at age 60 (crucially this figure also includes the value of their house), then it’s clear to see that placing all your money into an annuity will be unlikely to provide enough money for you to live off.

Also, the income paid by an annuity is taxed as income, and the annuity provider will usually deduct tax, using your tax code, before paying the net income to you. However, no National Insurance contributions are payable on income from annuities.

What’s your attitude to risk?

While some retirees choose to live off the returns from their stock market investments, there are others that prefer to buy an annuity instead. The reason for this is simple and is based on your attitude to risk. Although stock market investments have proven to out-perform the returns on annuities over the long term, they’re at the mercy of the wider economy, so if there’s a market crash then your income will crash alongside it. In contrast, buying an annuity will provide a historically lower income than keeping money invested in stocks, but the returns will be the same year after year, no matter what the rest of the economy is doing.

Some people choose a mix-and-match approach by using part of their nest egg to buy an annuity, part to take as a lump sum and keep the remainder invested in the stock market. This method of providing an income is an excellent way to achieve good market returns while still having the peace of mind that there will always be a fixed income available to cover any bills.

If you decide to go ahead and purchase an annuity at retirement time, you would be well-advised to speak to an independent financial advisor first. While insurance companies will give some advice, they are the ones selling the annuity product in the first place and so their advice comes with the risk of being somewhat biased towards their own products.

When selecting an annuity, there are several factors you need to consider, including:

  • Your age when the annuity starts.
  • The term of the annuity (lifetime or temporary annuity).
  • The amount available to buy the annuity.
  • Interest rates and anticipated future investment returns.
  • The options you select to be included.
  • Your state of health, and whether you smoke.

The amount of income you will receive when you buy an annuity can vary greatly between different providers, so you’re always best off shopping around to make sure you get the best deal. Luckily, there are now dozens of online search comparison sites that will tell you the rates that different providers are offering, along with all incurred fees and what the total annual income will be. Your search here can include such variables as; choosing to take part of your money as a tax-free lump sum, how often you want your payments to be made, and whether or not to link the annuity to inflation.

Inflation will gnaw away at your retirement fund

This last point is extremely important because inflation will gradually eat away at the income you receive. You can get around inflation to some extent by selecting an annuity product that will increase year on year by the current amount of inflation in your country. However, this income will be lower than a non-inflation linked product, so think carefully about how much you think inflation will increase by in the coming years. In the UK, inflation is currently around 2.5% per annum, but it rose as high as 25% in the 1970s.

One handy option to consider for your annuity is to purchase a guarantee period. A guarantee period will continue to make income payments even if you die shortly after taking out the product. This can be a good way of ensuring that your nearest and dearest will still have money coming into the household even if you’re no longer around to support them. The payments will continue until the end of the guarantee period, and will then stop at that point. You can also nominate a joint survivor to continue receiving this income if you are a couple living together with no other dependents at home.

It’s clear that while annuity products provide much lower returns than the stock market, they do at least provide a low-risk alternative that will provide a guaranteed income for the remainder of your old age. If your appetite for risk is a little higher though, it might be a useful strategy to keep some of your wealth invested in the stock market and use the remainder to buy the security that an annuity provides. The choice is yours.


Personal finance blogger who's fanatical about financial freedom, investing and making money in the UK

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