Annuities: As They Were, As They Are

Annuities are sold by life insurance companies. Traditionally, in return for your lump sum premium the insurance company paid you an income. The income was guaranteed for your lifetime.

Annuities paid a higher interest rate than banks could. This was because annuities and bank deposits were (and are) completely different. When you buy a lifetime annuity, you effectively sell your money for ever in return for an interest rate and lifetime income. Banks only have your money on loan; they don't get to keep it at the end of your life, so they cannot offer you as good a return as an annuity can.

For example, let's say you have accumulated $200,000 in a bank account and earn interest of 4% a year. If you take an annual income of $15,000 from this account, you will run out of money before 20 years have passed. The advantage of purchasing an annuity with your money is that you will get an income for as long as you live - even if it's another 40 years. Annuity Formula provides examples of how annuity calculations such as this are carried out.

Annuities have traditionally been used as a means of providing a lifetime pension. People saved while they worked and bought an annuity to provide an ongoing income in retirement.

Nowadays, innovations in financial products have led to a broadening of the meaning of an annuity.

What is an annuity?

An annuity is a regular income paid in exchange for a lump sum, usually the result of years of investing in an approved, tax-free pension scheme.

There are different types. The vast majority of annuities are conventional and pay a risk-free income that is a guaranteed for life. The amount you receive depends on how long the annuity provider expects you to live (i.e. how many years you'll need paying).

Insurance companies calculate this using age, whether you are male or female, the size of your pension fund and, in some circumstances, the state of your health.

A new Europe-wide law could ban providers from using gender, though. New 'unisex' unnuities would pay the same to men and women.

Find the right annuity for you

Are they good value?

Falling interest rates, poor stock market investment returns and greater life expectancy have seriously devalued annuities over the past few decades. In the early Nineties someone with a £100,000 pension pot might have retired on an annual income of £18,000. Today the same savings would give an annual income of nearer £6,000.

However, supporters of annuities point out that they offer absolute security for as long as you live. No other product does this and given that longevity is increasing rapidly - some 17% of Britons alive today will live to 100 - it's a major consideration. Level annuities will pay an unchanging income from the outset. An alternative is to buy an annuity that offers payments that rise in line with the RPI, thus maintaining the spending power of your income. But these often come at reduced initial rates. Another alternative is investment linked annuities, which track the stock markets to secure a better income year-on-year. Experts say that modern retirees may do well to explore a combination of these annuity forms.

Are they flexible?

No. Conventional annuities cannot be changed, transferred or surrendered for cash. This makes it essential to choose the best possible deal when the time comes to convert your pension savings into an income.

Newer annuities are becoming more flexible. For example you can buy 'fixed term' annuities which last for five years. And investment-linked products do provide some scope for changing your risk appetite.

Do I have to buy one?

Not necessarily. Until 6 April 2011, everyone is forced have to buy an annuity with their pension pot by the time they hit age 75. But new rules will allow some savers to avoid annuities altogether. Instead they are able to go into 'drawdown'. The new rules on this are complicated and deserve a whole guide of their own.

Advisers say drawdown is a realistic option only for those with large pension pots. You need to make considerable gains every year to maintain the sort of income provided by an annuity each year, and this puts you at the mercy of the stock markets.

Pensioners will need to show they've secured £20,000 of annual income before they can do whatever they like with their pot. Otherwise they are only allowed to withdraw amounts each year equal to what an annuity would pay. Until April 2011, pensioners can draw up to 120% of an equivalent annuity. From April onwards, this will fall to 100%.

Do I have to accept my pension company's offer?

Absolutely not. Your pension company will want you to choose its annuity offering, but the law says you don't have to. Everyone has the right to use the 'open market option' – shop around and choose the annuity that best suits their needs. A starting point could be to consult This is Money's annuity rate tables. There can often be a huge difference - up to 30% in some cases - between the highest and worst annuity rates available. This can amount to thousands of pounds over the average investor's retirement.

How will health affect annuity income?

You qualify for an 'enhanced' annuity, which pays a much better income, if you have certain medical conditions or are a smoker. That's because you're not expected to live as long as a healthy pensioner of the same age. Specialist insurers use this to your advantage: they will pay you a higher income because they calculate that, on average, your income should be paid out for a shorter period of time.

What else do I need to know?

Some older pension policies have special guarantees that mean they will pay a much higher rate than is usual. Guaranteed annuity rates (GARs) could result in an income twice or even three times as high as policies without a GAR. It's worth checking your options.