Life annuities are often known simply as annuities, but the longer form of the name makes plain a simple and important truth. Once you have researched life annuities and settled on a particular product, you have – after the short ‘cooling off’ period – made a decision that will stay with you for the rest of your life. Given the fact that life annuities are the vehicles that turn your pension pot into a retirement income, this choice could scarcely be more significant.
Those fortunate enough to have a defined benefit pension scheme, commonly known as a final salary pension, receive a pension income based on years of service without the need to buy an annuity. However, the majority of people in the UK have a defined contribution pension scheme, which amasses a pension pot that needs to be converted through life annuities into a regular income – the only other common exception to this is those that have never paid into a pension scheme, and will receive only a state pension.
After grasping the one-time nature of the deal, the next most important point about life annuities is that you have the right the shop around – you don’t need to arrange an annuity through your pension provider. In fact, it is probably more accurate to say that your ‘right’ to shop around is more like a duty, as the income yielded from the same pension pot can typically differ as much as 30%, when you compare the best and worst annuities on the market.
Like many financial products, annuities rates across the board can change on a regular basis, but the underlying trend in the long term has been that rates are going down. This is due to average life expectancy increasing, and providers having to pay out annuity incomes for longer. This means that holding off and waiting for rates to improve before buying an annuity is a questionable tactic, as the delay in converting the pension pot can simply mean missing out on a few months income. A much better strategy is to leave yourself plenty of time to make the decision, by starting to research life annuities before you retire.
Annuity income can be paid on a monthly, quarterly or annual basis. When it comes time to surrender the pension pot, it is possible to take a cash free lump sum of up to 25% of the fund. This will of course mean that there is less left to convert into life annuities, and so the regular income yielded will decrease. In this case, why would anyone take the lump sum?
Beyond taking that dream holiday, the simple answer is the uncertain nature of the future, or more precisely, the fact that no one can tell exactly when they will die. Standard annuities stop yielding income when the policy holder dies, and so an early exit can see a large pension pot effectively vanish overnight.
Many people with partners choose to opt for a joint life annuity, which continues to pay out a proportion of the original income after one partner dies, although this comes at the cost of a reduced income when the policy commences (when compared to standard annuity).