Annuity - an Overview

If you have any form of personal or money purchase pension you must buy an annuity no later than your age 75th birthday.

An annuity is an income paid to you for life by an insurance company (or similar) in return for your pension fund. Once you have purcahsed an annuity, you cannot usually change your mind and switch to a different one at a later stage. Nor can you get your money back if you die the day after buying one because annuities work by a system of cross subsidy - those who die early subsidise those who live to a ripe old age.

The beauty of annuities is that they pay an income for life - no matter how long you live. Annuity rates are currently historically low. A £100,000 pension fund today will provide roughly 60 percent of what you could have received a decade ago for the same fund, because conventional annuity rates are tied to bond yields which have collapsed from 12.4 percent in 1990 to around five percent in 2000.

The annuity market is highly competitive and you can improve on the income offered by your pension provider by up to 30 percent by shopping around on the open market. This is done by telling your pension provider that you want to use the "open market option"(OMO). You can then go to an annuity specialist who will seek out the best rate for the type of annuity you require.

Before shopping around for the best rates, remember to check your pension does not incorporate a "guaranteed annuity rate" which other insurers are unlikely to be able to beat.

The most commonly bought annuity is the "level payment" or "conventional" annuity. This will pay you the same amount of money each year for life.

If you want increasing payments you can take out an escalating annuity which will increase every year by any percentage you chose up to a maximum of 8.5 percent, but you will have to accept lower initial payments compared to that payable by level annuities.

An index-linked annuity also pays a lower initial income, but is guaranteed to rise in line with price inflation each year. Although inflation is currently low, it is worth remembering that inflation soared to 25 percent in the 1970s.

If you have a life threatening medical condition, smoke or are obese, insurance companies offer better rates via "impaired life" annuities because you have a shorter life expectancy than a healthy annuitant.

More risky, but offering some prospect of growth over the long term, are with profit annuities which invest your pension fund in the with profits fund of the annuity provider. But your income will fluctuate and could even go down, so they are best for those with other sources of income to fall back on.

Unit linked annuities are more risky still as they invest in unit linked funds so your income could be highly volatile. You should take advice on both with profit and unit linked annuities as they carry higher risk as well as the opportunity for higher returns.

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