Consider your options

Annuities aren’t sexy, but they are definitely having a moment. Sales are on the up, and more people look likely to take one out after changes to inheritance tax on pensions announced in October’s budget.

An annuity is a product that converts an individual’s pension pot into a regular guaranteed income for the rest of their life, or for a fixed term. You pay a life insurance company a lump sum, and in exchange it guarantees you a regular payout.

For a long time, annuities were viewed as poor value, and demand plummeted after the “pension freedoms” introduced a decade ago meant people no longer had to take one out. Years of low interest rates, plus increased life expectancy, also meant that annuity rates – the incomes you get from them – tumbled.

But the higher interest rates of recent years mean that people buying an annuity now get more bang for their buck. When interest rates rise, so do annuity rates.

“The stability of a guaranteed income gives retirees peace of mind that their money won’t run out even if they live past 100,” says Lorna Shah at Legal & General, a big annuity provider. “It takes the guesswork out of budgeting and lets people focus on enjoying retirement.”

You can use pension savings to buy an annuity once you are aged 55 – rising to 57 from April 2028.

The income you get from one is dependent on things such as your age and your health at the time you buy it.

Shop around

There are lots of different types, and once you buy an annuity, you can’t normally change your mind. So think carefully about which (if any) is right for you, and maybe take some advice.

Your existing pension provider is likely to contact you as you near retirement and offer to turn your pot into an annuity. But you don’t have to take its offer – you are free to shop around and buy one from any provider, and you are likely to get a better deal by doing so.

A 2019 report from the consumer group Which? found that moving to the best deal on the market could increase an individual’s retirement income by up to 20%.

Five years on, that still appears to be the case: data issued in the autumn by Just, a retirement specialist company, showed that “a healthy 75-year-old can secure 20% more income from the best annuity provider compared to the worst”.

“Failing to shop around when buying an annuity can easily lose pension savers thousands of pounds,” Just says.

Aside from L&G and Just, other big annuity providers include Standard Life, Aviva, Scottish Widows and Canada Life.

Lots of websites let you compare annuity rates and obtain quotes, including the government’s MoneyHelper website, Annuity Ready (part of L&G) and investment platform Hargreaves Lansdown.

“Not all providers will deal directly with you, so you may wish to consider professional financial advice or using an annuity broker,” says the MoneyHelper site. But check for any fees you may have to pay.

Weigh up terms

Rather than choosing an income for life, you could pick guaranteed regular payments for a set period – such as five or 10 years – plus maybe a lump sum at the end. This is known as a fixed-term annuity.

That might work for someone who wants a guaranteed income for a specified period – for example, to tide them over until their state pension kicks in or they downsize their home to release some cash. You could use all or part of your savings pot to buy it.

You also need to consider whether you want an annuity that just covers you (a single life annuity), or one that provides an income for your spouse, civil partner or another dependant after you die (a joint life annuity).

A single life annuity usually pays a higher income, but it will stop when you die. With a joint life annuity, your surviving partner or chosen dependant will receive a percentage of the income you were getting. You select this percentage – for example, 25% or 50%.

A “guarantee period” is an add-on you can buy that ensures your income will continue to be paid out for a minimum period (often five or 10 years), even if you die soon after taking out the annuity.

Choose level or escalating

You will need to choose whether you want your annuity income to stay the same or go up each year.

A level annuity will pay you the same income each year, while an escalating annuity provides an income that increases every year. With the latter, you can choose between an annual increase at a set rate – usually 3% or 5% – or one that is index-linked (adjusted each year in line with inflation).

Level annuities offer a much higher starting income, which is why they are by far the most popular option. An escalating annuity could end up paying out more each year in the long term, particularly if inflation is high.

Mention health issues

Anyone who has a medical condition, is overweight or smokes might be able to get a higher retirement income by opting for an enhanced or impaired life annuity.

This higher income reflects the fact that – to put it bluntly – your life expectancy is statistically lower than average, so the annuity provider probably won’t be paying out for as long. You could get as much as 30% more money than someone with no health issues.

Illnesses that may qualify include diabetes, chronic asthma, cancer and heart disease.

Mix and match

There are annuities, and there is drawdown, where your pension pot remains invested and you take a regular income, or sums of money as and when you need it.

But it’s not a choice between one and the other. You could use an annuity to cover your essential day-to-day expenses while keeping the rest in a drawdown arrangement, says a retirement expert, Helen Morrissey at Hargreaves Lansdown.

“This gives you the peace of mind of knowing that your day-to-day expenses can be met and that the rest of your pension remains invested, where it has the opportunity to grow further,” she says.

“One option can be to [buy an annuity] in slices throughout your retirement as your needs evolve. That way, you can still get investment growth from your drawdown pot but, as you annuitise, you can also get higher rates as you age.,”

Get a quote

At the start of January, a relatively healthy 65-year-old with a £100,000 pension pot could turn that into an annual income of £7,287 if they went for a single life level annuity with no guarantee period. If they took one out at age 75, the annual income would be £9,499.

If you made the income index-linked – using the retail prices index (RPI) measure – and added a five-year guarantee, those sums would fall to £4,786 and £6,959, respectively, in the first year.

If instead they went for a joint life level annuity where their surviving partner gets 50%, but with no guarantee period, the 65-year-old’s amount would be £6,692, and the 75-year-old’s £8,315. Tweak it so that the income goes up by 3% a year and it would be £4,769 and £6,533.

These figures were provided by Hargreaves Lansdown. To get a quote for your own circumstances, contact an annuity provider.