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What types of annuity are there?

Under the new pension rules that come into force from April, retirees will no longer be forced to buy an annuity and will be able to withdraw money from their pension pots as they see fit.

But research by the International Longevity Centre UK, a think tank that studies longevity and demographic change, has found that for lots of people, taking some kind of annuity may still make sense. The ILC found nearly 70% of savers with a defined contribution pension scheme favour having a guaranteed income for life in retirement.

Here, retiresavvy explains the main types of annuities on the market.

What is an annuity?

An annuity is a contract between yourself and an insurer that uses some or all of your accrued pension savings to buy an income for the rest of your life – essentially, in exchange for some or all of your pension pot, an insurer will pay you money every month. In recent years, annuities have been seen as poor value, due mainly to poor returns on government bonds (debt) that are often used by insurers to fund annuity payments.

But in some cases – particularly with annuities where the payout rises in line with inflation – the break-even point at which you will have got back the equivalent of what you paid for your annuity can be beyond many people’s reasonable life expectancy.

A recent review of the annuity market by the UK’s financial watchdog, the Financial Conduct Authority (FCA), found that in 80% of cases, retirees could have got a better deal on their annuity by shopping around, although only 60% did so, and of those eligible for enhanced or impaired life annuities (see below), over 90% would have got a better deal from shopping around.

What types of annuity are available?

Single life annuity

Single life annuities pay a guaranteed income to one individual for their entire life – but payments stop when they die.

Joint life annuity

Joint life annuities continue paying a guaranteed income to your spouse or partner after you die, although the amount may be lower than what was paid out when you were alive, dependent on the option selected.

Level annuity

Level annuities pay a set, unchanging level of income each year, so the ‘real value’, or what your money will buy, is eroded by inflation over time.

Escalating annuity

The money paid out by escalating annuities rises every year by a fixed amount – this can be either a set percentage or a rise based on the rate of inflation.

Enhanced/impaired annuity

Enhanced or impaired annuities offer a higher payout, based on medical or other factors that are likely to limit your lifespan, and so the insurer expects to pay out for a shorter period of time than a standard annuity. Things that might qualify for an enhanced annuity include lifestyle choices such as smoking, while life-limiting medical conditions such as cancer usually qualify for impaired annuities. The two terms are often used interchangeably, however.

With-profit annuity

In a with-profits product, the annuity is linked to an investment, which therefore gives the possibility of a higher income based on the investment’s performance. However, with-profits annuities can also be hit by investment management charges or other investment based fees, and the value of the investment may fluctuate over time, meaning income could fall.

Fixed-term annuity

Fixed-term annuities pay out a guaranteed sum for a fixed period – usually five or ten years – and have a value at the end that can then be used as the individual wants – such as buying a new annuity or for drawdown.

Guarantee periods and capital protection

Cautious customers may want to consider what they might leave to loved ones should they die early. Some annuities offer a ‘guarantee period’ of five or ten years that continue paying out even if you die. In most cases, should you die early, the annuity provider or insurance company will keep the balance of your pension pot, which can seem like poor value. Value or capital protected annuities are a relatively new product that returns the unpaid portion of your pension fund to your estate – tax dependent on age under new rules – should you die.

Buying an annuity

About six months before retirement, you will receive a ‘Wake Up’ pack from your pension provider, which provides details about your savings and next steps. However, the FCA has found that many retirees find wake up packs to be too long, too full of jargon and too confusing to be of much use.

But since, in most cases, buying an annuity is a one-off, irreversible decision, it’s important to get it right – or at least be comfortable that you’ve made the best decision based on the information you have. It might be worth seeking financial advice or guidance and, as the FCA’s own research shows, in the vast majority of cases, it does pay to shop around.

This article has been commissioned by retiresavvy and any opinions voiced are the author's own.

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