Annuities can be confusing, but you're not the only one
But it's a crucial financial concept to understand if you're going to retire.
The Association of British Insurers (ABI) reports that annuity rates have been rising steadily in recent years, and that annuity sales reached all-time highs in 2024.
As more people sought to guarantee a steady retirement income for life, sales of pension annuity contracts increased by 24% in 2024 to 89,600, exceeding the 2023 total and setting a new 10-year high.
The most crucial financial decision you will likely have to make if you are nearing retirement is whether or not to purchase an annuity. But the truth is that far too many people are unaware of what they are.
Annuities, in their most basic form, are agreements made between you and an insurer. You use some or all of your pension funds to purchase an annuity from an insurer. The insurer agrees to pay you an annual income for life or a predetermined period of time in exchange for your pension savings. That's it. You comprehend the fundamentals of annuities if you comprehend that.
New rules that gave over-55s much more flexibility with their pension savings were introduced in April 2015 with the introduction of pension freedoms. You can now take a tax-free lump sum of up to 25% of your pension fund and make flexible drawdowns, among other options. In addition to those modifications, annuities are now offered by more providers, giving consumers even more options.
Annuities might be the best choice for you if you want the assurance that comes with having a steady income in retirement. Given that it's a once-in-a-lifetime investment, here is all the information you require regarding annuities, their operation, and how to pick the best one for you.
What kinds of annuities are the most common?
1. Annuities for life
An income is assured for the rest of your life with a lifetime annuity. Your spending, age, health, and current annuity rates all affect how much you get. One advantage is that the amount you get is set. If you anticipate that your living expenses will stay relatively constant over the next several years, or if you are worried about your pension income outliving you, it might be a wise choice. Additionally, this option carries no investment risk, so you don't have to be concerned about your money's value increasing or decreasing.
The drawback of a lifetime annuity is that, should you not live as long as anticipated, you may receive less than you paid for it. Although some providers provide a lump sum payment or an ongoing income to your beneficiaries and loved ones, payments typically cease upon your death. Make sure to read the fine print because this will greatly depend on the provider that you select.
2. Annuities are level and increasing
As the name suggests, level annuities perform as promised. Throughout the duration of the annuity, they offer the same amount of income. If you don't expect your outgoings to increase significantly during this time, this might work for you.
An alternative is to purchase an escalating annuity, which offers an income that increases annually at a predetermined rate.
In a separate guide, we discuss the differences between level and inflation-lined annuities.
3. Linked to inflation annuity
When you take into account the constant effects of inflation, living on a fixed income can be a daunting idea. Your income is correlated with the growing cost of living if you purchase an inflation-linked annuity.
However, keep in mind that you will have to pay more for this pension income protection, and that your initial income from an inflation-linked annuity will be significantly less than that from a regular one.
4. Annuity with a fixed term
For a predetermined amount of time, typically five to ten years, but sometimes up to forty, this kind of an annuity ensures you a fixed income. The provider will take your money and make investments on your behalf when you withdraw funds from a fixed-term annuity. After the additional investment growth, this amount is given back to you less the amount you were paid during the predetermined time frame.
Until you reach the state pension age, they can be a good source of income. You could decide to purchase a fixed-term annuity at age 57, for instance, in order to receive income until you are 67 years old and eligible to receive your state pension. After that, you can decide to use your savings to create retirement income in another way or purchase another annuity.
When you remove the product, the maturity amount that you will receive at the end of the term is predetermined. In most cases, the money can go to a designated beneficiary in the event that you pass away before the term is up. Conversely, a lower annuity income will result in a higher maturity sum and the end.
5. Annuity linked to investments
A certain amount of risk is introduced into the decision-making process by these products. Here, a portion of your income is dependent on the performance of your investments, and another portion is guaranteed, much like in a standard annuity.
The remaining amount of your pension fund is invested, and additional income is paid out based on the returns. You get to choose the amount of guaranteed income you like.
When markets are doing well, you might earn more money, but if your investments don't do well, you might lose money.
6. Improved annuity
An enhanced annuity, which offers a higher income, may be available to you if your lifestyle or health condition could shorten your life expectancy.
For instance, if you smoke or have a medical condition like diabetes or high blood pressure, these annuities may pay up to 20% more than a regular annuity.
If you select this product, you will be subject to a thorough medical examination and might be required to present proof that you are eligible for this kind of annuity.
7. Either joint or single-life annuities
Your income ceases upon your death if you purchase a single-life annuity. However, if you are married or have a spouse, this may leave them without enough money after your passing.
Instead, you may choose to use a joint annuity, which will continue to pay your surviving spouse after you are gone. Since the provider anticipates paying out over a longer period of time, joint annuities usually pay a lower income.
How do rates for annuities operate?
Knowing exactly what kind of annuity you require is crucial, but so is comparing the options available and looking around for the best deals. The amount of retirement income you receive and annuity rates vary greatly.
The amount of your annual payout expressed as a percentage of your entire pension pot is known as the annuity rate. For instance, you will receive 5% of your savings back annually if your annuity rate is 5%. Therefore, an individual who has £100,000 worth of marijuana would earn £5,000 annually.
Elements that influence the annuity rate.
Your offered annuity rate and the income you receive are influenced by a number of factors. Because annuity rates are determined by life expectancy, the lower your anticipated lifespan, the higher your income will be.
The rates on corporate and government bonds also affect annuity rates. Pension funds are often invested in bonds by insurers, who then pay you from the profits. Insurers offer new annuities at reduced rates when bond yields are low because they are making less money.
How to purchase an annuity.
Your pension provider will get in touch with you as you get closer to retirement to discuss your options for using your pension fund, which may include purchasing an annuity. However, you are free to compare prices and choose a different provider if you are unhappy with your current one.
The ABI reports that in 2024, seven out of ten (69 percent) annuity purchasers changed their annuity provider from the one they used to hold their pension funds. The percentage has increased from 64% in 2023.
Although it may seem simpler to accept the annuity rate that your pension provider is offering, you might be losing out on a higher income if you don't compare it to what the rest of the market has to offer.
Annuity rates can differ by up to 20%, so comparing rates can increase your income by up to 5%, according to retirement expert Just Group.
You can compare the annuity rates offered by other providers using the government's MoneyHelper scheme's online comparison tool.
Aviva's head of individual annuities, Claire Reed, stated: "You could discuss your options with a financial adviser or a non-advised intermediary, also known as an annuity bureau or an annuity broking service. An annuity bureau can assist in locating the provider with the best annuity rate, but they cannot advise whether an annuity is the best course of action.
"A licensed financial advisor will take into account all of your retirement options as well as the particular kind of annuity that best suits your needs. This is crucial because one of the things to consider when purchasing an annuity is that, in most cases, the purchase cannot be reversed if your circumstances change later.
Your retirement objectives and required income will also be taken into account by an advisor. You will likely make up for this expense in retirement, even though you will have to pay for expert assistance.
A mix-and-match strategy might be your choice. With a portion of your pension, you could purchase an annuity and invest the rest in a flexible pension drawdown plan. For instance, an annuity income could pay your regular expenses while you take a flexible income from the remainder of your pension funds.
When to purchase an annuity.
When making an annuity purchase, carefully consider your options. Annuities are not required to be purchased when you retire. If you purchase an annuity too soon after retirement, you may lose out on potential future investment returns on your pension funds. To ensure you are covered until you reach state pension age, for instance, you may purchase a small annuity at age 60. Annuity income usually increases with age, so you may purchase another one later to take advantage of a higher rate.
Remember that purchasing an annuity is typically an irrevocable decision, so it is wise to give it careful thought.
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