Purchasing a retirement annuity with your pension fund is by far the largest investment decision most people will ever make. It is not only the huge sum of money involved that makes it important, but also the fact that, once selected, an annuity can never be changed.

The reason for a pension is to provide you with an income during your retirement years, and the traditional method used to achieve this is exchanging the proceeds for an annuity, which pays you an income for life.

Careful planning
Currently, the youngest age at which you can access your pension is 50, although this
will increase to 55 from 2010. Pension rules require you to either use the bulk of your pension fund (at least 75 per cent) to purchase your annuity when you retire, or defer this until you reach 75 at the latest (this is why they are also known as compulsory purchase annuities). As a result, most people start looking at their pension income options when they are nearing retirement.

There are many annuities available in today’s marketplace and, contrary to popular opinion, you do not have to opt for a product provided by the company that holds your pension fund.

Suzanne Greener, deputy editor of Investment Life & Pensions Moneyfacts, points out, ‘It is vital that pensioners do not fall into the trap of assuming that their existing pension provider will offer them the best deal, and instead take time to find the best deal to suit each individual’s lifestyle.’

A key element of pension rules is the Open Market Option. Under the Open Market Option, you are free to buy a compulsory purchase annuity from any provider in the market. Kate Marsden, marketing director of Find.co.uk, explains, ‘It is essential that you use your Open Market Option, which gives you the right to shop around for the best annuity rate when you come to retire, not just accept the rate offered by the company that managed your pension.’

Suitably appealing
The enduring appeal of annuities is that they provide a guaranteed income. There is a lot to be said for having that peace of mind. Most of the drawbacks centre on a perceived lack of value when handing over a substantial sum.

Annuities are generally provided by insurance companies. When someone buys an annuity, the insurance company invests the cash largely in low-risk government bonds, and it is the historically low yield on these that is responsible for currently dragging down annuity rates.

The other major factor that is contributing to lower rates is increasing life expectancy. Ian Owen, chairman of Partnership, explains, ‘It is a fact that we are living longer in retirement than ever before, but lower annuity rates mean people have to save
a lot more to get the same level of income in retirement.’

A range of options
The market for annuities is very competitive, but it can be broken down into four categories: standard, index-linked, enhanced and investment-linked.

Standard (or conventional) annuities are the favourite choice for most pensioners. The level of income available depends on gender, age and the economy. The annual income you receive is set at the outset and does not increase, however long you live
to collect it. If annuity income is set at £7,000 per year, that is what the annuitant (the person who buys the annuity) will get each year for the rest of their life.

However, it is possible to opt for an annuity that increases each year in line with inflation. These are known as index-linked annuities and are usually linked to the retail price index (RPI). Your income is adjusted each year to reflect changes in the RPI.
So, if the increase in the RPI is three per cent one year, then your income goes up three per cent, and if it is ten per cent next year then your income goes up by ten per cent. However, your income is not guaranteed to increase each year. If the RPI did not rise, nor would your income and, in the unlikely event that the RPI actually fell, so would your income.

An option available to some investors is an enhanced annuity. According to Chartwell Private Client, almost 40 per cent of people now entering retirement can enhance their annuity income further due to their current state of health. Put bluntly, if you have
a condition that means you are likely to die sooner rather than later, you can get a higher level of annuity income.

Nigel Callaghan, pensions analyst at Hargreaves Lansdown, comments, ‘This is the time to be honest. We go through life playing down our ailments, but when it comes to purchasing an annuity, you don’t have to be on your last legs in order to get a better rate.’

For example, smokers and the obese can improve their income by opting for what is known as a ‘lifestyle’ annuity. If you have a serious, life-reducing medical condition, you may be eligible for an ‘impaired life’ annuity, which will pay a higher income because of your reduced life expectancy.

Marsden points out, ‘If you are eligible for an impaired life annuity then this could improve your income by up to 40 per cent, compared to that payable by a standard annuity.’

Investing your annuity
For those in reasonable health, however, there is another way of securing a rising level of annuity income. Investment-linked annuities boost this income through purchasing an investment-linked product, usually based on the performance of with-profits or unit-linked funds.

In the early years, income may be no higher than a conventional annuity, and you also have to be prepared to accept a fluctuating income, instead of the level payments
of a conventional annuity.

The starting level of income for a with-profits annuity will depend on the ‘anticipated bonus rate’ chosen by the applicant. This means you are, in effect, receiving a part of the future growth from the fund in which you are investing. The higher the bonus, (usually up to five per cent) the higher the starting income. However, should the declared bonus rate be lower than the assumed bonus rate taken, your annuity income will fall.

Unit-linked annuities work in a similar way, except that the income level depends on the performance of the funds that they are linked to, which will rise and fall depending on the actual investment returns.

Get the timing right
Selecting exactly the right annuity to meet individual needs from the many options
and providers is crucial. Once you have bought an annuity, you cannot change your mind and switch to another provider or annuity type. And whichever type of annuity you buy, you will still need a hefty sum in order to obtain a decent income in retirement, particularly if life expectancy continues to increase.

Matt Ward, principal consultant for Wealth and Pensions Management at Defaqto, believes that ‘Choosing the right time to take your annuity depends specifically on your individual circumstances and your view on future annuity rates. When you decide to take your annuity is just as important as getting the right annuity from the right provider at the right price.’