10 steps to buying the right annuity
The Organisation for Economic Co-operation and Development (OECD) has attacked the government for making pension reforms that mean people are abandoning annuities and risking running out of money in retirement.
More than two thirds of retirees want the security of a guaranteed income that means they never run the risk of running out of cash, according to research from Hargreaves Lansdown. For most people, the best way to buy that security is with an annuity. Here’s our 10-step guide to getting it right.
1. Find out what your pension provider will offer you
Six months before you’re due to retire, your pension provider will send you a ‘wake-up pack’ telling you how much income you will get if you buy your annuity from them. You’ll usually be able to get a better deal elsewhere. However, if you bought your pension during the 1970s or 1980s, you may have a ‘GAR’ or guaranteed annuity rate that you’ll be unlikely to match on the open market. The catch is you may have to retire on a specified date and may not be able to arrange additional benefits such as guaranteed payments after you die. If you don’t have a GAR, you at least have a starting point for your own research.
2. Shop around
The difference between the best and worst payouts is around 12%, according to Moneyfacts, so it is essential you exercise your ‘open market option’ – this is your right to ditch your provider and shop around. Over a 20-year retirement on a £21,000 annuity, Hargreaves Lansdown reckons failure to shop around could see you miss out on £7,162 in income.
Unfortunately, most of us don’t bother to shop around. In fact, an astonishing 60% of people accept the annuity offered by their pension provider, according to the Financial Conduct Authority (FCA).
The FCA has announced plans to force annuity firms to tell people how much better off they would be if they shopped around. Providers will have to show customers the difference between their quote and the best quote on the market.
“Annuities still play a significant role in retirement provision,” says Christopher Woolard, executive director of strategy and competition at the FCA. “It’s important that consumers shop around to get the best deal for them. We believe that the proposals we have outlined will engage consumers and allow them to make better decisions, increasing shopping around and competition across the market.”
The FCA proposals won’t come into effect until September 2017. Until then, you’ll need to put in the legwork to shop around yourself, but it is easy with comparison websites. After answering a series of questions, the site will come up with a list of the top-paying providers. Check a few sites as not all include every provider.
3. Decide how long you want to annuitise for
Lifetime annuities pay out until you die. However, if you aren’t happy tying up your money for life, you could opt for a fixed-term annuity. “You choose the term and the final sum you want repaid to you and then we work back from there to work out what income we can offer you,” explains Vanessa Owen, head of annuities at LV=. Fixed-term annuities, however, are not available from every annuity provider.
4. ’Fess up to any vices or health problems
Shopping around will massively increase your annuity income, but it isn’t the end of the road. The vast majority of retirees could also increase their income by getting an enhanced annuity. Enhanced annuities pay more to individuals with medical problems or habits that give them a shorter life expectancy. According to Tom McPhail, Hargreaves Lansdown’s head of retirement policy, 75% of annuity purchasers could get an enhanced annuity.
Admit to all your vices and health problems, and you could significantly increase your retirement income. According to figures from Hargreaves Lansdown, a 65-year-old smoker with high blood pressure and high cholesterol and a £45,000 fund would get £2,962.44 a year, almost 40% more than they would get with a standard annuity. Someone with a serious impairment could almost double their income.
But don’t take up smoking now just to get a better rate. You need to have been smoking long enough for it to seriously impair your life expectancy in order for it to boost your annuity income.
5. Think about your dependants
Before you buy your annuity, think about anyone that relies on you for money. Once you have died, how will they pay the bills? Joint-life annuities ensure your income won’t stop until you’ve both passed away. You can opt for 100% of income to be paid, or select a lower proportion such as half or two-thirds. Joint-life annuities pay a lower level of income than single-life annuities, but failure to protect a spouse could leave them impoverished if they don’t have another income once you’re gone.
6. Do you want to protect your money?
When you die, annuity payments stop. This means if you die early on in your contract, huge sums of money may go straight back to your insurer. If you are concerned about not getting value for money, you can plump for guarantees. These ensure payments will be made for a fixed period, irrespective of when you die. These can stretch for as long as 30 years.
Alternatively, you can choose value protection, which returnsany remaining funds when you die. Again, both these options will reduce the income you receive.
7. Think about inflation
Often dubbed the ‘silent thief’, the power of inflation to reduce the spending power of your money should not be underestimated. Looking back over the past 30 years, the cost of goods and services has risen by 173.66% according to Office for National Statistics data. To put that into perspective, you’ll now need around £2,736 to replicate the spending power of £1,000 in December 1986. For this reason, you can choose an income that increases in line with inflation.
However, while this might seem sensible, it will reduce the initial income you receive and you may have to live a very long time to get value for money. An investment-linked annuity may offer better protection from inflation. This is because your money remains invested, giving it the potential to deliver a rising income. Your income however can fall if your investment doesn’t perform well, although most plans offer minimum income guarantees to provide a degree of protection.
Just how important inflation protection is for you will depend on how much of your total income your annuity accounts for. If you have other money invested or in an income drawdown plan, that should provide you with some hedge against inflation, making it less important than those retirees who are more reliant on their annuity.
8. Double-check your rate
Once you have found the insurer that will pay the highest income, structured in the way that you require, you’re ready to apply. However, if during the application process, you have made any changes, it is important to go back to the market. With a different set of requirements, you may find another insurer will offer a better income.
9. Be certain of your choice
After an initial cooling-off period, in which you can cancel your contract, your annuity will become irrevocable and you will not be able to change or switch your plan. Given that you will probably be handing over a sizeable chunk of your retirement savings, make sure you completely understand the annuity you have chosen, and are absolutely certain it is the best product for your retirement income needs.
10. Don’t discredit advice
Buying an annuity is a major decision that will affect your income and financial security for the rest of your life. There are few times in life where it is more important to get professional advice. It may seem pricey, but if an independent financial adviser can help you increase your retirement income it could be worthwhile over the longer term. Read our article about how to find a financial adviser.
You can get a good deal online, but don’t assume it’s free. Annuity brokers take a commission that reduces the income you’ll receive. This could be around 1.5% to 2.5% on a standard annuity, rising to 5% for enhanced annuities, according to the FCA. You can often get advice for a similar sum with the benefit of consumer protection in case you are missold an annuity.
Shrinking number of annuity providers
Prudential has announced it will not offer its annuities on the open market and, in future, will only offer them to existing customers. After the recent merger of Just Retirement and Partnership, this latest move provides further evidence that the number of annuity providers is shrinking.
There are now around 10 main players in the market, including Aegon, Aviva, LV=, Scottish Widows and Retirement Advantage. Prudential previously flagged up its intention to withdraw on the grounds that the new stricter Solvency II rules for pension providers make it harder to run the business profitably.
The worry is that, with fewer annuity providers offering products in the open market, more and more investors may end up bypassing the shopping around process and simply buy an income from their existing provider.
Recent research from Citizens Advice showed that seven in 10 investors are not shopping around when sorting out their retirement income.
The Organisation for Economic Cooperation and Development was established in 1961 to promote policies that will improve the economic and social wellbeing of people around the world. It uses a broad range of economic information and research to help governments foster prosperity and fight poverty through economic growth and financial stability and also ensure the environmental implications of economic and social development are taken into account. It can only make recommendations and has no powers of legislation; nor can it compel members to adopt any recommendation. Based in Paris, the OECD currently has 34 members, including the UK.
Open market option
People who have a money purchase or defined contribution pension, at retirement must use their fund (minus an optional 25% as tax-free cash) to purchase an annuity. As the annuity market is very competitive and rates differ vastly between annuity providers on a daily basis, the open market option is your right to shop around and buy the annuity from the company offering the highest rates at that time.
An alternative to an annuity, income drawdown (also known as an unsecured pension) allows you to take income from your pension fund while the fund remains invested and so continues to benefit from any fund growth. The drawdown of income has to be calculated carefully as taking too much income could exhaust the pension fund so experts say the annual drawdown must not exceed what the assets would normally yield in an average year. The invested pension fund could also be hit by market turbulence and the value of the assets could fall.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
The period of time you’re allowed, after signing an agreement, to cancel it without incurring a financial penalty. Financial products including banking, credit, insurance, personal pensions and investments are subject to a 14-day cooling-off period (this is 30 days in the case of life insurance and personal pensions). The insurer or broker must refund any money paid by you within 30 days, although it has the right to deduct a reasonable admin charge, and a sum proportionate to the number of days’ cover you had. If you have any related credit agreements, these will also be cancelled.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.