What you should think about when buying an annuity
It's a cliché to say that buying an annuity is a decision that will affect you for the rest of your life. But it's a cliché for a reason. So it's worth spending a little bit of time to get it right. Read on for the things you need to think about when you making your decision.
Not everyone wants or needs to buy an annuity but it can be a useful and important of many people's retirement portfolios.
I should point out that this is not advice. I can't know your individual situation and what it best for you. You might like to think about taking professional financial advice from someone who knows the market where you live and can tailor their answers to your personal circumstances.
An annuity is partly an investment, but it is also a form of insurance. It protects you against living so long you run out of savings. So when buying an annuity think about it in terms of insurance as well as an investment.
How valuable that protection is to you will depend on your circumstances, but if used wisely annuities can be a a really useful tool for your retirement portfolio.
What is an annuity?
In simple terms an annuity is a product you buy from an insurance company: you give them money (either a lump sum or regular payments while you are working) and in exchange they will give you an income for the rest of your life.
People can worry about whether annuities will be a "good bet". I would suggest you don't worry too much about whether you "get your money back" ie live long enough to make it worth while. Don't think of an annuity as a bet or a speculative investment. Think of an annuity as insurance - it's guaranteed income that will make sure you can still eat and heat your home when you are in your nineties. And if you don't live that long? At that point you won't be around to worry about it.
Understand your pension
If you are not yet at the stage of actually buying an annuity but just want to know how pensions and retirement planning works, why not have a look at these article that will give you the questions you need to ask about your pension plan, or an introduction to pensions and retirement plans in general
1. Should you buy one?
For most people buying an annuity to live off when you retire makes sense - it guarantees your income which gives you some security. We all know how up and down the financial markets can be!
But that won't be true for everyone. If you already have substantial savings or income from other sources you might be able to afford to take a bit more of a risk for higher returns on your money.
Depending on the rules in your country you may have to buy an annuity with your pension pot. In other places you may have a choice of other products that allow you to leave your money invested in the markets. You should also investigate the tax implications (income, capital gains and inheritance taxes amongst others) of these products and how that affects your situation.
But, as I said before, if you need a stable secure income when you are retired you will probably want to buy an annuity.
2. Should you buy one now?
If you decide you are one of the majority of people for who buying an annuity is a good idea, you should still think about whether it is the right time to buy one now.
If you delay and market prices of annuities don't change you will generally get a higher income (because it will be paid for less time), but there is always a risk that annuities will get more expensive overall while you delay. Of course there is also a chance they will become cheaper.
It may help to have an idea of the income you need in retirement. You could then keep working and delay your retirement until you can buy an annuity with that level of monthly income. But not everyone will have the luxury of deciding when to retire.
Learn more about the kinds of assets you can invest in, and investment strategies
If you want to learn more about the different assets you could invest in and different strategies for investment then take a look at these other hubs:
3. Should your annuity be investment-linked?
It is also possible to buy annuities that give you some extra return from a link to an investment product. There are lots of ways to do this and there are many different products available in different countries.
Generally you would expect to do better from an investment-linked annuity than from a conventional one, but there is always a risk that if your investments don't do as well as expected you could lose out. On the other hand they may also do better than expected.
You should only consider these products if you can live comfortably off the guaranteed income and any extra investment return is a bonus. And don't forget the effect of inflation. As time goes on your money will not go as far as it used to. So even if you are comfortable on your income now, think about whether you will still be comfortable in the future. And of course your needs may change as you get older.
If you are thinking about buying an investment-linked annuity (like a unit-linked annuity or a with-profits annuity) then it is worth taking independent financial advice from a suitably qualified adviser or financial planner.
4. Should you pay for your annuity to increase each year? And should it be inflation-linked?
A non-increasing annuity will give you the biggest income now. But the danger is that by having no increases on your pension, you won't get any increase to help you when the cost of living rises (we've all seen how your money doesn't go as far as it used to).
If your increases are linked to some index of inflation (such as the Retail Prices Index (RPI)) then that will give you some protection against the cost of living increasing more than you expected and leaving you unable to afford as much as you thought. But remember that these indices are based on the average across the whole country. Your costs might go up faster (or slower) than average so it doesn't guarantee you won't lose out. However it is much safer than not having inflation-linked increases.
Also if you live longer than generally expected you will lose out if you choose a non-increasing annuity. This is because of the cost of living going up. It's also because the insurance company will set the price of the annuity based on how long they expect you to live. If you live longer with an increasing annuity you will get more increases than they expected and be better off (compared to a non-increasing annuity). Of course if you die sooner you would be better off with a non-increasing annuity - although at that point you might no longer care!
5. What about your spouse/partner?
If you have a husband or wife or a partner, or if you have young children or you should also think about what income they will need after you have passed on. With most annuities you can pay extra to provide some income for your spouse or dependants after your death.
This can cost a reasonable amount so it is worth thinking about what your dependants are likely to need once your gone. Most annuities will allow you to choose the level of income provided for your dependants as a percentage of yours. Typically people might choose 50% or 66% or even 100% income for their spouse, but you should consider your own situation. How much will they need to live on? What other income do they have (such as a pension of their own)?
As always, if in doubt, consider taking independent advice. And do talk about it with your spouse or partner, so you both know what to expect.
6. Should you pay extra for a capital protection guarantee?
One downside of an annuity is that if you die soon after you buy it, it can seem like a waste of money. But with most annuities you can pay a little extra for a capital protection guarantee. With that you are guaranteed that the annuity will last for at least a set number of years.
For example if you bought an annuity at age 65 with ten years capital protection and then unfortunately died at age 68 your estate would get the next seven years of annuity payments. (In practice these payments would often be made in one lump sum.)
This can be a good way of making sure your annuity feels like value for money if the worst does happen and typically doesn't add very much to the cost.
7. Are you in poor health? Do you smoke?
If you have a health condition that means that you're less likely to live a long time, or if your a smoker or in some other situations, then you can often get an annuity that pays a higher income than a normal healthy non-smoker. This is one situation where being in ill-health or being a smoker can be to your advantage.
This is because the insurance company doesn't expect you to live for as long so the money you pay to buy the annuity doesn't have to last for as many years as it would for a person in normal health. If you are suffering from poor health or are a regular smoker make sure you find out whether that could get you a better income.
For most people buying an annuity is really good way to get a secure income in retirement. Don't think of them as an investment. Think of them as insurance against having a miserable old age. Like all insurance you may be theoretically better off taking the risk yourself but unless you are wealthy enough to cope with large fluctuations in income I don't think it is worth the possibility of poverty in retirement.
If you do want to buy an annuity there are a lot of option out there and you may want to get some specialised advice. I trust this article has helped you to think about the kind of annuity you might want to buy, when you might want to buy one, and, of course, if you want to buy one at all.