The best ways to use an annuity

If you’ve decided to buy an annuity with some or all of your retirement money, the next step is to choose the right type and incorporate it into your wider financial planning in the most effective way.

A key decision is whether to opt for an inflation-linked or level annuity. The former tend to offer a much lower starting income, but one that always rises with inflation, and vice versa for the latter. A level annuity runs the risk that your annuity income will not cover your real expenditure in future, although often retirees' expenditure reduces as they get older. Another factor is whether you have other sources or assets you can rely on if an annuity lost some of its spending power – particularly if those assets are inflation-linked. See The best type of annuity to buy (IC 9 June 23).

On top of this, you need to decide if you want your annuity to include enhancements or protections, especially if you want to provide for a spouse or partner after you die. You could buy a joint-life rather than a single-life annuity, which would continue to pay income to a beneficiary – usually your spouse or partner – if you die before them. As part of this process, you decide what proportion of the level of income you were receiving will continue to be paid after you pass away. This could be important if your spouse/partner does not have many assets or income of their own. If you are under age 75 when you die, your surviving dependant won't pay tax on the income paid to them. If not, tax will be charged at their marginal income tax rate. 

However, the rates you get on joint-life products are lower than those of a single-life annuity. So if, for example, your partner has state and/or defined-benefit (DB) pensions that will cover their needs, and/or you are going to leave them substantial assets, a joint annuity may not be necessary.

Other ways to provide for a beneficiary include an annuity that continues to pay income until a set guarantee period ends – even if you die before the end of that period. This might be good if, for example, your spouse is due to start receiving their state and/or a DB pension in, say, a decade's time, and you purchase a guarantee period of 10 years to cover them until that point. Again, these do not pay as high a rate as annuities without guarantees.

Some investors choose to draw down from defined-contribution pensions such as a self-invested personal pension (Sipp) rather than purchase an annuity at all, one reason being that they can leave whatever is left in the pot to a beneficiary. With conventional annuities (joint annuities aside), that isn't the case. However, there is another option: value-protected annuities return to beneficiaries the amount of money used to buy the product, minus the value of the income payments received.

You could also opt to protect part of the original capital you used to buy the annuity – for example 25, 50 or 75 per cent of it – to pay out as a lump sum to beneficiaries on your death, should this initial capital still be left over. If you’re under age 75 when you die, any sum paid to your beneficiary is not taxed. If you die when you are 75 or older any lump sum paid to your beneficiary, dependant or estate is taxed at their highest rate.

However, protecting some or all of your capital means that you will receive a lower income than you would from a conventional annuity. The more of your initial capital you protect, the lower your income will be.

If you are looking to bridge the gap between when you retire and when you start to receive a state or DB pension, Claire Altman, managing director for individual retirement at Standard Life, suggests purchasing a fixed-term annuity that pays out an income over a set number of years. Note that, unlike other types of annuities, these don’t take into account medical conditions, so you can’t receive an enhanced rate. But if you die before the end of the fixed term, it will continue to pay out to your estate or a beneficiary for the remainder of the period. You can choose a period of typically between three and 25 years, although five and 10 years are more common.

Getting the best rate possible

When you have chosen your preferred type of annuity, it is important to compare different providers’ quotes: the best deal available could pay several hundred pounds a year more than the worst. When discussing the annuity purchase with a broker or provider, disclose full personal details of your health and lifestyle as “all factors that might influence your life expectancy are relevant”, says Altman. “The rate is higher the more conditions you have.”

Stephen Lowe, director at retirement specialist Just Group, adds that about two-thirds of retirees secure a higher income as a result of their health and lifestyle factors. “Ask your pension savings provider or annuity broker if they use full medical underwriting and have access to rates across the whole market,” he advises. “If they don’t, find another who does, otherwise you may get a bad deal that could cost you thousands of pounds in lost retirement income.”

Lifestyle information includes things such as your body mass index, which can be used to determine if you are under or overweight, as over time these can affect your health; your smoking history and your alcohol intake. Medical information includes diagnosed conditions such as high blood pressure, high cholesterol, diabetes and cancer.

“Our underwriting process, for example, takes into account up to 250 pieces of information,” says Lowe. “Annuities also provide an important ‘risk-free’ benchmark against which other options involving more risk [such as drawdown] should be compared. Your own personalised rate may be a lot higher than standard rates published in best buy tables.”

Don't ditch drawdown

Rather than annuitising all of your pension pot, you could annuitise part of it and draw from other assets. Advisers suggest covering the costs of essential spending such as food, utilities, insurance and transport with a secure income, such as state and DB pensions. If you do not receive these or they do not fully cover your essential spending, you could buy annuity income of a value that makes up the shortfall. You could cover discretionary spending on, for example, hobbies and holidays, by drawing from cash savings, individual savings accounts (Isas) and pensions in drawdown.

When deciding whether to opt for both drawdown and an annuity, or just one of these, as well as other savings you should consider the value of any mortgage on your home, as well as your tax position.

Having income that comes from both a secure source such as an annuity and drawdown means that essential spending is covered – as long as these costs don’t increase above the value of your secure income. And some of your money could still benefit from investment growth and, if you don’t use it, pass to beneficiaries after you die. You can also choose how much you take from the non-annuity portion of your assets and when you receive it (rather than receiving regular set payments), which could help to reduce your tax liability. And if you draw from Isas, cash or pensions tax-free money, it is not liable to income tax.

However, Ian Cook, chartered financial planner at Quilter, says that “this is only a situation that can be considered if you know that [secure] income [such as] from the state pension plus an annuity is likely to cover all or most of your living costs”.

Annuity rates are typically higher at older ages. “Health tends to worsen as we get older, so a person’s life expectancy could reduce [and] the retirement income attained from a medically underwritten annuity may increase if purchased later in life,” notes Lowe. Annuitising later in life or in stages throughout your retirement could also mitigate the impact of inflation on the value of level annuities’ income because each tranche you buy might pay out a larger amount of money. It is possible that annuity rates across the market will not be as high in future, but rates improving due to age should offset some of this risk.