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The Citywire Money guide to annuities and retirement income

Buying an annuity is one of the most important financial decisions you'll make. Read our guide and avoid some common pitfalls.


on Jul 21, 2012 at 00:01

The most common way to save for old age is through a pension, but how exactly do you get the money out of your pension pot when you retire?

Unfortunately you can’t just take all the money and run – although that would be nice. The government wants you to turn that lump of money into a steady income that you can live on.

The most widely used way to do that is to buy an annuity from an insurance company. You give your pension pot to an insurance company and it pays you an income for the rest of your life.

Here’s a few things you need to know about annuities.

Annuities are an insurance contract against living too long

If you buy an annuity and then die a week later your family don’t get your pension cash back – the insurance company keeps it. Although you can, for a price, add your spouse on to your annuity they get some benefit when you die.

Many people are critical of annuities because the money goes back to the insurer but you don’t ask for your home insurance premiums back if you don’t claim on your home insurance, this is no different.

There are lots of different types of annuities

The amount of income you get from your annuity depends on what you’ve saved and how long the insurance company expects you to live based on factors such as medical history, lifestyle and gender.

Women get lower rates because they live for longer. A woman of 65 with a £100,000 pension pot can expect to get an income of £5607 a year compared with £5,889 for a man.

Income can also be affected by the type of annuity you choose.

A fixed term or level annuity pays out the same amount each month until you die but doesn’t protect your income from inflation.

A way to tackle inflation is to buy an increasing annuity where income increases as you get older or buy an investment-linked annuity where you money is linked to the ups and downs of the stockmarket.

If you have an existing medical condition or an unhealthy lifestyle you could also get a higher income.

You can’t change your annuity

Whatever decision you make you make about annuities you have to make sure it’s the right one because once you’ve bought an annuity that’s it – there’s no second chance and you’re locked in for life.

It’s worth noting that annuities aren’t the only way to turn your pension into an income – you can also use income drawdown.

This is where you money stays invested and you take an income from it. Although this provides more flexibility, your pension pot remains invested so can fall and any remaining money left when you die is subject to a 55% tax charge.

Annuity rates aren’t great

Annuity rates – the amount of income an annuity will produce – have fallen to new lows. This is because annuities are invested in gilts: a way to loan the government money for a set return.

The yield – or return the government gives you – has hit an all-time low of 1.49% on 10-year gilts; and the lower the yield then the lower the income.

Gilts are low because of a number of things. The eurozone crisis has a lot to do with it because UK government debt is seen as a safe haven. Quantitative easing isn’t helping either. As the government prints more money it buys up gilts, pushing up the price but pushing down the yield.

For example a 65-year-old man with a £100,000 pension pot would have received an annuity of over £15,000 a year in 1990 but now, he’d receive just £6,000 a year.

Annuities are still a good idea

Despite poor rates and criticism, you shouldn’t be put off; annuities are still a good buy for many people.

The most obvious benefit is they provide you with a guaranteed income. Yes, you lose your money if you die too early but what about if you live longer than expected? Your annuity could end up being a very good deal.

Rates are low but there is scope to increase annuity income depending on the annuity you buy.

Finally, don’t forget about the 25% tax-free lump sum you can take when you cash your pension pot.

The truth is most people don’t save enough and annuities are a good way to stretch smaller savings pots but if you want to get the most from your pension it’s always best to consult an independent financial adviser who will be able to find you the best annuity rate.

If you're new to annuities and want to know more you've come to the right place. In the video above Michelle McGagh takes you through the basics. Below we've selected some of our best articles for beginners on annuities, and you'll find more links on to the right.

Most of these articles first appeared on . This is a part of the Citywire Money website dedicated to anyone looking to learn the basics about finance. Sign up for the weekly Lolly email if you’d like to know more by clicking on the link above.

• What is an annuity and how does it work?

• How to buy an annuity

• Drawdown v annuities: which pension strategy wins?

• Your finances after retirement

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