In simplest terms an annuity is an agreement to pay out a regular sum in return for a one-off investment. For example, if you could gave me £100 I could agree to give you back £10 a year for a set number of years.
In practice, annuities are a little like a ‘reverse life insurance’ policy and act as a way for you to release the value in your pension fund when you retire.
You spend your working life building up a nice fat pension pot. When you retire you hand that over to an insurance company by purchasing an annuity. In return the company selling the annuity agrees to pay out a set percentage of that amount each year for the rest of your lifetime (lifetime annuity). At the end of your lifetime whatever is left over is pocketed by the insurance company.
So, if you bought an annuity for £500,000 at 7%, then the provider would then have to pay out £35,000 a year for either an agreed number of years or until you pass away – in effect, giving you a regular income of £35k for life.
The longer you live the more you get.
You Don’t Have to Buy Your Annuity from Your Pension Provider
Many people are under the mistaken impression that they have to buy their annuity from the company that provides their pension – you don’t. Just like any other insurance product you can, and should, shop around to find yourself the best annuity rates available. If you make a mistake or enter into an annuity blindly you could be unnecessarily reducing your annual income in retirement – for the rest of your life.
You can even personalise your annuity to suit your own personal income requirements. For example, you may choose to have the amount paid out increase with inflation – especially useful if you plan on enjoying a good long retirement – or run for a maximum or minimum number of years.
Of course they still need to make money so the amount you are paid annually will be based on factors such as age, sex and the current bond rates (i.e. how much they can earn from investments). It’s not the nicest thought, but the insurance company ‘wins’ if you die sooner rather than later. Therefore, buying an annuity at 60 will almost certainly mean that it pays out less each year than one bought at 70 (but you do get an extra 10 years of income).
Is your annuity the single most important personal finance question in your retirement?
It could be, yes.
Annuities are certainly one of the most secure ways for you to provide yourself with a guaranteed income for life. However, once an annuity is purchased it cannot be moved or changed in any way. With that in mind, it is hugely important that you find an annuity that suits your needs.
In other words you need to get annuity advice to get the best annuity rates.
Shop around, get expert advice and speak to an independent financial adviser – but whatever you do, don’t just take the first annuity that’s put in front of you by your pension provider. Whatever you choose, you’re going to have to live with it.
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