If you’ve saved into a defined contribution pension scheme during your working life, you’ll have to decide what to do with the pension fund you’ve built up when you approach retirement age. One option is to buy a lifetime annuity (often called just an annuity).
What is an annuity?
An annuity converts your savings into an annual pension, giving you a guaranteed income for life, or a specified period.
In the video below Paul Lewis, financial expert and presenter of BBC Radio 4's Moneybox, talks about annuities and gives his tips on planning for retirement.
You don’t have to purchase an annuity if you don’t want to. Instead, if you have been a member of a defined contribution pension scheme, you have various options for your pension pot. These other options may affect your decision about whether to buy an annuity, so consider them carefully.
What are the different types of annuity?
If you decide to buy an annuity, it’s vital that you shop around for the best value to get the most from your pension pot. Different types of annuities will suit different people’s needs and circumstances.
You will need to consider whether you want your annuity to rise annually with inflation (which will cost you more) or if you'd rather be paid the same amount each year.
A level annuity will pay you the same income each year. They have a higher starting income than an escalating annuity, but they can leave you vulnerable to inflation, which might make your annuity income worth less over time. Even low levels of inflation can significantly reduce your standard of living.
An escalating annuity will rise each year at a fixed rate. It may start lower than a level annuity, but the amount it pays you will increase at a fixed rate (e.g. 3%) each year.
An inflation-linked annuity will rise each year in line with the retail price index. This protects your annuity against inflation, but it will start at a much lower rate.
You will also need to consider your particular circumstances, such as your health, whether you want to receive an annuity income over a short or long term, and whether you want to leave an income to a spouse or partner after your death.
Impaired or enhanced annuities
These pay out a higher income if your health or lifestyle may shorten your lifespan, for example, if you have an existing health condition or you smoke or are overweight. It is important ensure that any provider you speak to asks you your health so they can properly consider whether you are eligible for an impaired or enhanced annuity, as the income rates may be considerably better than other types of annuity.
These will pay you an income for the rest of your life, unlike a short-term or fixed-term annuity (see below).
Joint life annuities
These will pay an income to your spouse or partner after your death, but this is usually at a lower rate.
Short-term or fixed-term annuities
You can use part of your pension pot to buy an annuity that provides a short-term income. The rest of your pot is left invested, and you can still choose to buy a lifetime annuity when your short-term one expires. You might choose a short-term annuity if you don’t want to commit your pension fund to a life annuity as you believe rates might get better in the future.
Where can I buy an annuity?
You don't have to buy your annuity from your pension provider, and you should shop around.
Start by checking what your pension provider is offering, because they may still offer a higher payment rate than those available elsewhere. But you don't have to go with them, and you can shop around for the best deal - this is known as the open market option.
Contact The Pensions Advisory Service for free information and guidance on comparing annuities from different providers
What should I do next?
Before you make any decisions about your pension, it’s important to consider the consequences:
- think about your long-term plans - you’ll be able to make better decisions about your pension if you've thought about what you want from retirement
- talk to your pension provider to find out the options available to you
- get independent advice - you can get more information from the Money Advice Service, and if you need to talk to someone, contact The Pensions Advisory Service
- remember that while you can take the first 25% of your pension pot tax free, you'll get charged income tax on any additional money you take, and you may also need to consider the impact on your eligibility for state benefits or care services
- be aware of pension scams - a cold caller may contact you to give you pension advice, saying they have your details and have Government backing. Hang up, as this is likely to be a scam.