What is an annuity?

Older people Retirees have an important decision to make when choosing an annuity

Annuities have been a vital part of the pension system for millions of people, but the chancellor has announced plans that ride a coach and horses through the industry.

Not everyone needs to buy an annuity, but those who do so only have one shot - as they are buying a retirement income for the rest of their lives.

The system has been described as "disorderly" by the City watchdog, and now Chancellor George Osborne has said that many people will no longer need to buy one.

So, what are annuities and how do they work?

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What is an annuity?

Individuals save into a pension during their working life and so build up a pension pot.

At some point during the first years of retirement, they will usually use the money that they have saved to buy an annuity from an insurance company.

This is a transaction that occurs once, and only once.

An annuity is an annual retirement income that is paid to them for the rest of their life.

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Does everyone need to buy one?

No. Those with final-salary pensions will be awarded a pension pot linked to their salary when they finish work, so will not need an annuity.

Pension schemes explained

  • Final-salary scheme: Guaranteed pension based on earnings at end of your career and length of service. Also known as defined benefit schemes
  • Career average scheme: Guaranteed pension based on your average pay over your career
  • Defined contribution scheme: Determined by contributions and investment returns. Usually worth less than final-salary pensions. Savings used to buy an annuity, or retirement income - until now

The state pension is also unconnected to annuities.

But, for many of those who save into a defined contribution pension, there was an effective requirement to buy an annuity or face a hefty penalty.

The latest estimate is that 420,000 annuities are sold every year. As more and more people are enrolled automatically into a workplace pension, these annuities were expected to become even more common.

But in the 2014 Budget, the chancellor said he planned to scrap the requirement for those with defined contribution pensions to buy an annuity. Instead they will get free advice to decide what is best for them with regards to their pension pot.

This could mean people taking a big chunk of their savings pot to spend early in the retirement, although they will have to pay income tax on that.

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What choices will I have?

Essentially, if you have saved for a pension, you will have a pot of money and you can decide what to do with it.

You may invest it yourself, you may spend it on a property, or - unsustainably - have a very good holiday.

But many people may still think that an annuity remains the best option, although the chancellor's changes may affect the competitiveness of deals.

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Does everyone get the same deal with annuities?

Absolutely not.

First, there are standard annuities - available to all. Then there are enhanced annuities that can be bought by people with a lower life expectancy, generally smokers or those with a medical condition.

The latter are more generous because the insurance company is betting that they will not have to make the annual payment for very long.

When it comes to buying an annuity, retirees need to look at the rates on offer.

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A bit like finding a good savings rate?

Yes, a little like that.

Just like savings, the financial crisis has had a big effect on the rates on offer. For many years rates were falling, but they did start to recover last year.

Ultimately, retirees need to shop around for a good rate, and often take a guess on the best timing. If they think the annuity rate might rise, then they might delay buying an annuity.

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So how does a provider calculate what to pay out?

When you hand over your pension pot to a provider, they tend to invest that money in long-term government bonds, typically a 15 year gilt. The return they can offer you depends on the interest rate, or yield, on that bond. Over the year to March 2014, those yields rose from around 2.2% to 3.2%. As a result overall annuity rates have risen from around 5% to 6%.

Longevity is also an important factor. As people live longer, insurance companies expect to pay out more, in effect lowering the returns that pensioners can get.

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Are annuities good value?

As mentioned above, this issue is already being investigated by the regulator, the Financial Conduct Authority. Some pension companies make up to 25% of their profits from annuities, according to analysts at JP Morgan.

Pensions expert Dr Ros Altmann believes that profit margins on some annuity products are as high as 18%.

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Do I need to buy the annuity from the same company I saved with?

No. You have the right to shop around.

A review by the Financial Conduct Authority found that six out of 10 people stick with their original pension provider.

Some 80% of those could have had a better deal if they had got their annuity from a different provider.

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Where can I go for help?

This is a big financial decision and one you only make once, so it is well worthwhile doing your homework.

The independent Pensions Advisory Service and the government-backed Money Advice Service offer explanation and calculators.

But the government has promised that everyone will have access to independent advice when the new rules come in.

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