Annuities have formed the mainstay of retirement income for as long as there have been pensions and they still provide the largest proportion of private pension income. They are a straightforward income provider with a bundle of excellent qualities that dovetail perfectly with many people’s retirement revenue needs. 

Apart from being the most popular way to take benefits from a pension, annuities are also the simplest to understand. You are exchanging your pension fund with an insurance company in return for a guarantee that it will pay you an income for the rest of your life.

However, many of the plus points of an annuity can just as easily be interpreted as  a negative if you’re looking at them from the other direction, not least an annuity is usually fixed for life, which can be both desirable and undesirable in equal measure.

The older you are when you buy an annuity the fewer years the insurance company will expect to have to pay you a pension so the higher your pension will be, for example it could be 10 per cent higher at age 65 than it would have been at age 60 for the same size fund.

Lifestyle factors will also play a part; smoking is not usually considered a lifestyle benefit but if you enjoy the occasional puff you will be made extra welcome by annuity providers as smokers on average tend to inhale for the final time five years before non smokers of the same age. This results in a superior annuity rate for nicotine addicts. 

We’ve known for a long time that if you live in Newcastle the chances are you will expire before your counterparts in Kensington for reasons we are all familiar with (hard graft, too many nights on the Quayside etc). The latest social profiling techniques used by annuity providers are simply refining this concept and distilling their longevity predictions to such a degree that is possible to be living on different sides of the same street and be quoted different annuity rates.

A big factor that will influence your personal annuity rate is the state of your health.  Increasingly annuities are being ‘underwritten’ in the same way as life assurance policies to take account of any health factors that may reduce your lifespan.  Medically there are a whole list of very obvious conditions such as cancer, heart disease, diabetes and then a whole lot of less obvious ones such as your height to  weight ratio. Essentially the closer you are to death’s door, ideally pushing right against it, the better annuity income you will get.

You have the choice of adding various options to your pension annuity at the outset.  These options will affect your lifetime income and all come at a cost, so there is an element of gambling involved.

Your pension annuity can continue to be paid to your spouse if you predecease them and you have options in respect of the level of pension you would like them to have. Should you die first you have wasted your money so the cost of this benefit will be a key factor in reaching your decision, the younger your spouse the more expensive it will be.  

One of the most common and justified complaints about annuities is that should you die early in retirement you lose out. One way to mitigate this potential loss is to purchase a guarantee and if you die during the guaranteed period, which is normally five or 10 years, the balance of any payments due would be paid to your dependants or your estate.

Alternatively, you may now purchase a 'value protected' annuity offering a lump sum death benefit (subject to tax of course) equal to the amount you paid for the annuity less the pension payments paid to date .    

What do you think the rate of inflation is going to be over the next 20 years? If you want to purchase an annuity that increases at 3 per cent per annum it will reduce your initial income by around a third. Once again this is a decision that is all part of the annuity gamble.

Although I don’t want you to get the impression that I think annuities are a bad idea, if you live to be 120 that annuity will just keep on paying month after month after month. 

In simple terms if you are receiving 6.5 per cent a year from your annuity, by your 16th year of retirement you have had your money back and are there then running at a profit.  If you die before that 16th year of course it is less of a good deal. There are other ways to take your pension income but that’s why gamblers prefer annuities!

By Paul Steel, financial planner at Estate Matters Financial