What is Annuity? And How does it Work?
What is annuity: getting the most from your life savings
What is annuity? We all know we should save a pension when we can work so that we can afford to live comfortably when we don’t. It’s generally understood that we each have a pot, amassed over the course of our working lives, from which we will one day draw out our pension, but how exactly does this work? How does our pension pot know how long we’ll live once we retire? And what happens when the money runs out?
The answer is that your pension isn’t that simple. The money we save into our pension fund isn’t the money that comes back to us in our retirement. Instead, we use the funds we’ve accrued to buy an annuity.
What is annuity?
An annuity is a lot like an insurance policy that covers you if you live too long. Of course that doesn’t sound so attractive, hence the term annuity. Essentially, it allows you to swap your pension savings for a guaranteed regular income that can be paid monthly, quarterly, half-yearly, or yearly for the remainder of your life.
“Essentially, [an annuity] allows you to swap your pension savings for a guaranteed regular income for the remainder of your life.”
You give the lump sum that you’ve accrued through your pension savings to an annuity provider, who then gives you an income according to their estimates of your likely longevity. The annuity provider is essentially betting against you, over how long you live after retirement. If you expire relatively rapidly, they win. If you live to a ripe old age, you do. Those individuals who pass away quickly effectively subsidise the ones who live to get a telegram from the Queen.
How is the annuity rate worked out?
The annuity rate you receive – that is the level of income that your pension will buy you – is calculated using a number of different factors.
- Firstly and probably most obviously, the younger you live to be, the poorer the deal you’ll receive. This is because your annuity provider will expect to be paying out much longer, as they’re anticipating that you’ll live a long time after the first claim. This means the older you are when you arrange your annuity, the better the rate you can expect to get.
- It’s also normal for men to receive a better annuity rate than women because typically they don’t live as long.
- Your own health and lifestyle come in for consideration too, as these may give an indication of how long you’ll survive. If your lifestyle is less healthy, you can expect a better rate. So much for justice!
External factors that could influence your annuity rate
Other external factors can affect the annuity rate too. When you hand over that lump sum to the annuity provider, you’re at the mercy of the prevailing economic situation. They will invest your money, hoping for sufficient returns to keep paying incomes to all the retirees on their books, so naturally if conditions are difficult but they’re still supporting pensioners who bought their annuities in better times, the rate you get may be reduced.
Such is the nature of the annuities business that most providers aren’t willing to take risks to maximise their income. By and large they’ll go for the safest investments, such as gilts, which over recent years haven’t performed so well.
How to proceed
It can be a difficult situation if you retire when the markets are particularly slow. This has been the case for many who’ve retired over recent years, and this has been behind many of the government’s changes to pension rules, which they’ve introduced in order to try and get retirees a better deal.
“Time was, buying an annuity was the only way you could use your pension, but changes announced in 2015 have opened up the options enormously.”
However, at the end of the day you’re not obliged to take the annuity offered by your pension provider, you can shop around for better deals on the open market. If you’re in this position now, it’s well worth comparing the products on offer to get the best rate.
Download our free guide for help
Time was, buying an annuity was the only way you could use your pension, but changes announced in 2015 have opened up the options for pensioners enormously. It’s even now possible for you to trade in your annuity in return for a lump sum.
For more information about annuities and your other options, download our free guide to annuities. From key questions like “what is annuity?” to our personal advice about how to approach your pension, it contains everything you need to know to make more confident, informed retirement choices. It was written by us for you, so you can get the most from your life’s savings.