Dr Ros Altmann Unless you have a final salary scheme, your pension will consist of two, entirely separate, parts.
1. The pension fund: this is the long-term investment fund that builds up from all contributions paid in over the years.
2. The annuity: this is what you must buy with your pension fund (by age 75) to pay your pension for the rest of your life. In other words, an annuity is your actual pension.
Only insurance companies can sell annuities. They take all the money in your pension fund and will pay you a monthly pension for the rest of your life in exchange.
If you die the day after buying the annuity, the insurance company keeps your money and you have had a raw deal, but if you live for many decades you will have had a very good payout. In other words, those who die young subsidise those who live longer than expected, so an annuity is a type of insurance against living 'too long'.
Annuities are unique. They are the only product that the Government forces you to buy and once you have bought your annuity you are stuck with it for the rest of your life, you can never change it. Of course, this makes it essential to choose the right annuity in the first place.
Also, annuity rates vary significantly from one company to the next, sometimes by 20 per cent or more, so it is really important to shop around for the best deal. Most people do not know how to do this, so you probably need a financial adviser to help you.
What you should remember is that your pension company will offer you a pension - which will be your annuity - when you reach retirement age, but the company which managed your pension contributions over the years may not actually be the best one to buy your annuity from. It is easiest to just accept the pension you are offered, but you may come to regret that later.
Your pension company must offer you what is called an 'open market option', which means informing you that you might find a better annuity rate with a different provider. But, unless you know where to look and what you are looking for, this can be of little use.
Taking this 'open market option' requires filling in lots of forms and can take time to get the paperwork done. This means you should think about annuities a few months before you want to retire, otherwise you may be forced just to accept a poor rate in order to get a pension quickly.
Understanding the annuity market is often a vital part of retirement planning.