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Five steps to choosing the right annuity

Chris Torney / 10 March 2020

How do you go about choosing the annuity that’s right for you? We look at the different types of annuities, and whether they're still worth buying.

An older lady approaching retirement carefully chooses an annuity

There are several types of annuities and different providers will offer customers differing terms, conditions and rates.

What is an annuity?

An annuity is a financial product sold by an insurance company which guarantees to pay the holder a certain amount of money every month for the rest of their life.

How much an annuity pays out depends on a number of factors, including how much money is in your pension pot, how old you are when you buy your annuity, what annuity rates in general are like when you buy it, and what the state of your health is.

Since 2015, it has been easier for people to leave money invested in their pensions while taking a regular income – a process known as drawdown – instead of using their funds to buy annuities.

Are annuities still worth it?

In recent years, annuities have become less popular as rates have fallen. But there are still good reasons for using at least some of your money to buy an annuity:

  • Your money won’t run out: if you take too much income from your pension or the investments don’t grow as much as you’d expected, there is a chance that your fund will run out at some point, leaving you with just your state pension to live on. This is not something you'll need to worry about with an annuity.
  • No more tricky decisions: If you buy an annuity instead of keeping money invested, you won’t have to make any more decisions about how to fund your retirement – for example, whether to change the risk levels in your pension savings, or if you should change the amount of income you take.
  • More money for people in poor health: If you have a medical condition such as diabetes or heart problems, you could be entitled to higher levels of annuity income. The amount you get depends on your life expectancy: people with shorter life expectancies get higher payments.

Whether an annuity is the best option for you or not depends on your own circumstances, and it is always a good idea to seek guidance from an independent advisor when making major decisions about your finances in retirement.

But if you do decide to buy an annuity, how do you go about choosing the deal that’s right for you?

Step 1: Look at your income options

Before looking for an annuity deal, you need to decide what your overall strategy is going to be: for example, do you want all of your pension fund to be used to buy an annuity, or do you want some to be left invested? Perhaps it would suit you better to wait a few years until you buy an annuity: the older you are when you apply, the more income you will get, other things being equal.

Step 2: Work out your annuity requirements

At the most basic level, annuities guarantee to pay you a certain monthly income for the rest of your life in return for a cash lump sum up front. But there are a number of optional extras you could choose.

For example, do you want your annuity income to be linked to inflation? If so, you will get less in the early years, but your payments will keep up with rising prices.

And do you want the annuity to keep paying your spouse if you died before them? If so, look at joint annuities: but again, this extra protection means your income rate will be lower.

Step 3: Find out if you are entitled to a higher rate

If you have any health conditions such as diabetes, high blood pressure or heart disease, you could be entitled to a higher rate as you will probably be viewed as having a shorter life expectancy. Be sure to mention any medical problems on your application.

Step 4: Shop around for the right deal

Get as many quotes as you can for the annuity you need: rates can vary significantly between providers and getting the most competitive deal now can mean thousands of pounds in extra income over the course of your retirement.

Use an online annuity comparison service to compare deals or talk to your financial adviser.

Step 5: Understand there is no going back

A few years ago, the government announced plans to allow annuities to be sold for a cash lump sum – but these proposals were scrapped after widespread criticism. As a result, annuities remain irreversible: once you have signed up, there is no going back.

This means it is vital you get the right kind of annuity and the best possible rate at the first attempt.

Mistakes to avoid

1. Accepting the first offer

When you reach your pension scheme’s retirement age, your pension provider will write to you to talk about your income options. The chances are, they will give you a quote for an annuity as well.

However, it would be foolish to accept this quote without working out whether the type of annuity they are offering is right for you, and without checking if you can get a better deal from a rival provider.

Always shop around for the best possible rate: doing so could mean thousands of pounds in extra income over the course of your retirement.

The Money Advice Service provides an annuity comparison tool

2. Hiding medical problems

Unlike medical or travel insurance, for example, you could get a better annuity rate if you are in poor health.

Income levels are based on life expectancy: the longer an annuity provider expects to pay out for, the lower the monthly rate will be.

When you apply for an annuity, be sure to mention any health issues you face, such as whether you smoke or suffer from conditions such as diabetes, heart disease or cancer.

3. Ignoring inflation

Standard annuities pay a flat level of income for the rest of your life. But if you sign up for one, there is a big risk that your income will be eroded by the effect of rising prices.

You should therefore consider taking out an inflation-linked annuity: although this means that payments will be lower in the early years, it could offer you much-needed protection against price increases later in your life.

4. Forgetting your spouse

It is worth thinking about what happens to your spouse if they are relying on your income in retirement and you die before they do. Joint annuities guarantee to keep making payments to a surviving partner after the holder’s death.

5. Putting all your eggs in one basket

Pension rules introduced in 2015 mean that you don’t have to buy an annuity when you reach retirement: instead, you can leave your fund invested in the stock market and hopefully benefit from future growth.

Increasingly, people are taking a mix-and-match approach to their retirement finances, with part of their pension funds used to buy an annuity and the rest left invested.

There may be no need to put all of your savings into an annuity, so make sure you explore your options and seek advice if necessary to work out what approach suits you best.

Find out how to get trustworthy pensions advice

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The opinions expressed are those of the author and are not held by Saga unless specifically stated. The material is for general information only and does not constitute investment, tax, legal, medical or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.