Until April 2015, the most common way for people to use their pensions to provide an income over the course of retirement was to buy an annuity.
An annuity is a product that converts a chunk of cash into a guaranteed monthly income for the rest of an individual’s life.
New pension rules, however, mean that savers now have more freedom to choose how to use their funds – so if they don’t want to buy an annuity they can leave their money invested in the stock market, for example, while making regular withdrawals to cover living expenses.
So what are the advantages and disadvantages of annuities? Do they still have a role to play?
Six reasons to switch your pension today
What are the advantages of buying an annuity?
Guaranteed income
The money you get from an annuity can never run out: the provider guarantees to pay you a certain amount every month, however long you live.
No falls in value
This income will remain at the same level and it will not fall if there is a stock market crash, say.
Protection against inflation
Some annuities – known as index-linked annuities or rising annuities – pay a higher monthly amount every year in order to counter the effects of inflation. But this feature comes at a cost, and income in the early years will be lower than with a level annuity.
Income for your spouse
A joint-life annuity can continue paying an income to your husband or wife after you die.
Higher income for people with health problems
If you suffer from a medical condition, such as heart disease or diabetes, you could be entitled to a higher annuity income due to your lower life expectancy.
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... and the disadvantages of buying an annuity
Annuities are irreversible
Once you have entered into an annuity contract, you generally cannot change your mind and cash it in (although there are plans to allow annuities to be sold in some circumstances – the government is currently consulting on how such a system would work).
Rates are low
As a result of the financial crisis and rising life expectancy, annuity rates today are about as low as they have ever been.
No chance of growth
If you left your money invested in the stock market, you could make considerable gains if share values rise – this could help provide a more comfortable retirement.
(Of course, the opposite is also true, and you could lose money and see your income and savings diminish.)
Inflation can eat away at your income
If you opt for a level annuity, your income can lose much of its spending power over time as a result of inflation.
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Your annuity strategy
If you have no other savings or assets, buying an annuity with at least some of your pension can help provide a guaranteed income that, combined with your state pension, covers your basic living expenses.
If you have other sources of retirement income, on the other hand, you may be happier to take more risk with your savings and carry on investing in the stock market.
Money expert Annie Shaw answers a reader's question on the pros and cons of annuities:
Are annuities always bad?
Annie's answer:
On the contrary. Annuities have had a bad press, but are still the main way to secure a guaranteed income for the whole of your life from your retirement savings.
Annuities may seem poor value for a number of reasons, not least increasing longevity. The annuity provider, which previously would have been expected to pay out for, say, eight or 12 years post-retirement may need now to provide an income from the same money for 20 years or more, so what you get each year is less.
But don’t write annuities off.
The key thing to remember is that an annuity is insurance against outliving your money. You hand over a lump sum to the insurance company and are guaranteed cash every month or year until you die – no matter how long you live.
Special rates are available for those with a shortened life expectancy.
Pension freedoms have given people more choice in how they spend their retirement savings, and investing oneself will make sense for many people.
Don’t, however, overestimate your investment skills, or your ability to manage if you get it wrong and your cash runs out.
An annuity might not be right for you, but it might well be.
Always take professional financial advice on how to make the most of your retirement savings. DIY could be a recipe for disaster
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