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For those who value the prospect of a good night’s sleep in retirement, an annuity is the only financial product that will offer the certainty of a secure income in later life.
Money saved in a pension plan is given to an insurer, who turns the lump sum into a guaranteed lifetime income for the policyholder and any spouses attached to the contract.
The concept of paying out a flow, or stream, of income to a person or even a family dates from the Roman empire. The annuity concept has survived throughout the centuries and, today, an estimated 6m policies are providing a regular income to retirees throughout the UK.
But in spite of the peace of mind the policies can offer, annuities have fallen out of favour.
The first quarter of this year saw a dramatic drop in annuity sales, with only 20,000 policies taken out compared with 70,000 the same time a year ago, according to the Association of British Insurers (ABI), the trade body.
This development followed big reforms, which removed the requirement for people to buy an annuity at retirement.
“People see annuities as ghastly, poor value products that they were forced into buying,” says Patrick Connolly, certified financial planner with Chase de Vere, independent financial advisers.
“When they were given the choice not to buy them, when new reforms came into effect in April, they have stopped purchasing them in large numbers.”
While many savers are exploring new ways to spend their pension pots, such as treating themselves to cars, holidays or keeping their money invested in “drawdown”, advisers say annuities still have a role to play in a retirement strategy.
“The starting point should be that everybody needs enough income to cover their basic living costs in retirement,” adds Mr Connolly.
“That secure income could come from the state pension, a defined benefit pension or a combination of both. But if the income from those is inadequate they should be using funds to secure an annuity.”
With an annuity, the rate offered in exchange for a lump sum is determined by a number of factors, including the policyholder’s age, where they live (used by insurers as a proxy for life expectancy), the size of their fund and their health. Annuity rates are also sensitive to movements in interest rates.
Whether the annuity income is “joint life” or continues to pay to a spouse, or has a money-back guarantee attached, or rises with inflation, will also influence the rate offered to the principal policyholder.
A 65-year-old man buying an annuity today, with a £100,000 pension fund, which carried a five-year money back guarantee and no tax-free cash, could expect an annual income of about £5,500. However, he would need to live at least 19 years to break even on his capital.
Pension experts say those looking for an annuity could boost their retirement income in a number of ways.
“Annuities become better value the older you are, so if you are below the age of 65, in good health and have a decent sized pension fund it might be better to delay your annuity purchase until you are older if you can take income in another way, for instance through income drawdown,” says Billy Burrows, an independent retirement options expert.
|Most common conditions in order||Annual income||20-year income||Difference|
|High blood pressure||£5,709||£114,182||+£6,185|
|Chronic respiratory disease||£5,959||£119,186||+£11,189|
|Atrial fibrillation (abnormal heart rhythm)||£5,802||£116,038||+£8,040|
|Average healthy person||£5,400||£107,998||n/a|
Enhanced, or impaired life, annuities can also pay significantly higher income to those who are in poorer health, or who have a lifestyle that could limit their life expectancy. Conditions take into account high blood pressure, snoring, which could indicate sleep apnoea, an underlying health problem, and smoking.
Just Retirement, an enhanced annuity provider, says the uplift on standard rates could be as much as 17 per cent if the policyholder has mild medical conditions and up to 40 per cent if they are smokers.
Advisers note that recent policy changes have meant that income drawdown is more attractive to those who want to pass their pension pot to heirs. When an annuitant and a joint life policyholder dies, what remains of the annuity fund will pass to the insurer, not heirs, unless there is value protection on the policy.
However, advisers say annuities can still be a sensible retirement option for many thanks to the guaranteed nature of the income.
“Not everyone wants to take investment risk with their pension in retirement,” says Justin Modray, founder of Candid Financial Advice, the independent financial advisers.
Those considering an annuity should shop around and get advice if they want the most suitable policy and the best rate.
“There are some firms who can arrange without advice but it is nearly always better to get financial advice,” adds Mr Burrows.
“Finally, don’t forget to have all your health information to hand because if you qualify for an enhanced annuity you will get a higher income.”