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A beginner’s guide to annuities

Annuities are a key part of retirement planning but haven’t got a very good name at the moment. They are blamed for many problems which are not their fault. One problem with annuities is that most people don’t understand them! Another problem with annuities is that people have bought them carelessly without understanding what they have bought.
A third problem with annuities is that they are solving a problem that most people don’t recognise exists, that most people are going to live a lot longer than they bargain for.
Trained actuary Henry Tapper unravels some of the mystery and confusion. He explores:
  • The issues surrounding annuities
  • A simple explanation of what an annuity is and how it works
  • Options for making the most of them, including the importance of good pension advice.

The most common form of annuity and how they work

The annuities I am going to talk about in this article do a very simple job, they are called ‘purchased life annuities’, because you buy them for the rest of your life, to provide you with the kind of life you want in retirement. The deal is this: an insurance company takes a view on how long you are going to live and then works out a sum of money it is going to have to put aside, to guarantee it will pay you this amount till you die. It then tells you how much it needs from you to pay you an income.

How providers set their prices

So, supposing I am 60 years old and a man and in pretty good health, the insurance company might work out that I can be expected to live another 30 years. I might want the money to be paid to my wife after I died. For every £1,000 per annum that I want paid out, the insurance company might demand £30,000 from me, being the amount they expect to pay out.
Except it won’t cost them that much as they can get interest on the money I give them which can go some way to offsetting the cost to them of the guaranteed promise. So they might discount that £30,000 to £20,000, reckoning they can get the rest in interest. This is how insurance companies ‘price annuities’.
Now there are all kinds of wrinkles that affect the price. Your state of health for a start. The insurer should be looking at whether you have an unhealthy lifestyle (smoking, drinking etc.),whether you have a history of early death in the family and whether you have any medical conditions that make you likely to die sooner than the average.
All of this will bring down the cost of paying you your £1,000 a year. The insurer can tell a lot from where you live (some Chelsea postcodes have a 17 year longer life-expectancy for residents than some postcodes in Tottenham, and it’s nothing to do with football!).
And as well as health, there’s the question of what you mean by ‘£1,000’. If you want that £1,000 to keep pace with inflation, then it’s going to cost more.
If you think inflation will be 3% per annum it might cost 15% more to link that £1000 to inflation, but if you think it will run at 5%, that 15% could go up to 25% more. And this uncertainty makes it even more expensive, because the insurance company has to put money by in case inflation is 7% or even 10%. This process of ‘putting money by’ or ‘reserving’ as insurers call it, is a menace!
There are a stack of EU rules about reserving that are designed to make sure an insurance company does not go bust. The trouble is that they mean the cost of an annuity is a lot higher. The extra security of UK annuities makes them almost 20% more expensive than the equivalent American product.

Getting the best deal you can

Buying an annuity is a complex decision
UK Annuities are amongst the most regulated, and therefore among the safest, ways of investing your money you can find anywhere on the planet. The trouble is that that safety comes at a price.
People planning for retirement, and considering buying an annuity, need to consider whether they want to pay that price. If so, they need to then make absolutely sure they get the price down by fully declaring all their medical problems to encourage insurers to drop their prices.
People buying an annuity should take quotes from every insurer in the market and they should think long and hard about whether it’s right that the annuity ends with them or whether a spouse, partner and even the kids need some protection if they die early.
As you’ve probably worked out for yourself right now, buying an annuity, like buying a house or a business is not something you do without taking good advice. Many people will need help not just working out what kind of annuity to buy, but when to buy it. You may not need the guarantees now, when you are relatively young, but in 10 or fifteen years’ time, things may be different.

Don’t make rash decisions – seek expert advice

So if you’re a beginner, don’t buy an annuity by yourself. The people who should be buying an annuity should be experts! A good independent adviser can make you an expert, you can make an expert of yourself, but if you use your pension pot to buy an annuity and take the first offer that comes your way, more fool you.
This article has been commissioned by retiresavvy and any opinions voiced are the author's own.


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