Don't be rushed into choosing an annuity deal

It's one of the most important financial decisions people make, but few hunt out the best option.
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The Independent Online

These are not good times to be retired or about to retire. Savings rates are at historic lows with some accounts yielding close to 0 per cent interest. People relying on their pensions may have had nasty shocks as stock market falls resulting from the credit crunch and recession have eaten into retirement savings. There seems to be little upside, and this is especially true for those who have reached retirement and are looking to exchange their pension pot for an annuity, in effect an income for life.

Annuity rates – the amount of regular income savers can get for their savings – have plummeted of late, not least because of the Government's programme of quantitative easing. This process, which involved the Government buying back its own gilts, has led to a 50-year low in gilt yields. Insurance companies, which base their annuity pay rates on these gilts, have been cutting back. Figures from independent financial advisers Hargreaves Lansdown show that while in August 2008, a male aged 65 with a pension fund of £100,000 could buy an income of £7,901 (with no inflation proofing), today he could get £7,067. That's a drop of nearly 15 per cent in income in just eight months.

Against such a backdrop, the strategy must be to maximise annuity returns for your pension pot. Unfortunately, people generally spend little time choosing their annuity and those that get it wrong will pay dearly.

Annuities essentially work by exchanging pension money for a secure income. An abundance of annuity types are available, but most advisers warn against taking out an annuity with your pension provider. Instead, it is best to take what is known as the "open market option" and scan the deals on offer from a variety of providers. The Financial Services Authority (FSA) says this can increase your income by as much as a third. Despite this, it's still a good idea to check the rate offered by your provider and use this as a benchmark when shopping around. The FSA website (www.fsa.org.uk) has useful annuity tables for comparing products.

A conventional, or level, annuity guarantees a fixed income until you die. This security comes at a price, as the pension fund will not be passed on to the estate upon death. Couples may decide to take out a joint life annuity. Although single life annuities pay a higher level of income than joint life annuities, payments stop when the holder dies. A joint life annuity will continue to pay out for the remaining partner at a reduced rate (set when the annuity is taken out).

Another annuity option that provides some protection is to add a guarantee period. This means that income payments will continue to be made to your estate for a set period of time, even if you die within that period. Without these add-ons, all income payments stop upon death and the insurance company reaps the benefits.

Individuals can also choose to arrange their annuities so that they receive an amount that grows year on year. These escalating annuities can be set to increase by a fixed amount, say, 3 per cent per year, or by the Retail Prices Index. However, inflation-linked annuities tend to be more expensive and start off paying a lower amount, typically between 30 and 40 per cent less. Although inflation levels are currently negative, escalating annuities are a useful way to combat the general trend of a rising cost of living, which can erode spending power quickly. Tom McPhail of Hargreaves Lansdown says: "Looking a little further out, a by-product of quantitative easing is that we may see inflation coming back into the system. We would urge anyone to make sure they've built some inflation-proofing into their retirement income."

Enhanced annuities are another way to maximise returns. These pay a higher rate of return for those with medical conditions which might be expected to reduce life expectancy. For serious medical conditions, there are "impaired life annuities" which pay a considerably higher income for individuals with a low life expectancy. Some providers, for example Legal & General and Norwich Union, even offer enhanced rates for inhabitants of areas with lower-than-average life expectancy.

Income levels from a with-profits annuity are linked to the performance of the insurance company's with-profits fund. An individual who opts for a with-profits annuity product must set an anticipated bonus rate (ABR). This is then used to set the income level. For example, Prudential recently launched the Income Choice Annuity which allows customers to select the income they wish to receive and have the option of changing that level every two years. Income is based on Prudential's with-profits fund and so will either grow or fall depending on performance. As with all with-profits annuities, if the fund suffers, payments shrink.

But Adrian Lowcock of advisers Bestinvest says: "There is a distinct lack of transparency. At the end of the year, you will get a figure but you don't have much control or information about how that figure was reached." However, to offset this risk, there is a guaranteed secure level of income – the minimum level that payments cannot fall below. "If they can manage at that level it could work well," says Mr Lowcock.

Those willing to take chances can opt for an investment-linked, or unit-linked annuity. These potentially offer better returns in the long run, but management charges can be hefty and the annuity income paid is based on the ups and downs of the stock market. A more drastic way to maximise annuity returns is to put off purchasing one until rates have improved.

The most common alternative to an annuity is to enter income drawdown. "In this you can take an income from the fund and take out a tax-free lump sum – 25 per cent of the fund value. The underlying fund can be invested as you see fit and used to buy an annuity at a later date, when rates have improved," says Mr Lowcock. But delaying is dangerous. The future may bring even lower annuity rates.

A limited period annuity may be a better option for those who wish to ride out the recession. These last five years, after which you can switch to a new annuity. Customers could, though, find even less attractive rates around when it comes time to switch.

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