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.

To discuss your financial future in more detail, call us today on 01993 772 467 or get in touch online. We’re always happy to help.

Dominic

About the Author

Dom is a qualified and experienced Chartered Financial Planner (CII) and Chartered Wealth Manager CFP (CISI) and a Registered Life Planner (Kinder Institute) with over 30 years experience. His work primarily focuses on retirement income planning, helping clients to maintain financial dignity and independence in retirement. Read more from Dominic...
This article is distributed for educational purposes and should not be considered investment advice or an offer of any product for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. Past performance is not indicative of future results and no representation is made that the stated results will be replicated.
Let me say that we are really pleased with your approach and advice. We particularly enjoy your "finance is just part of your life" philosophy, as I know that what you offer and what we buy are different. We are buying reassurance, big time (because finance is part of our lives and we only have one life). You offer your expertise, organisation, attention to detail, interpersonal skills and methodology. You are giving us reassurance, so thank you! C.L. (Oxford)

Expert Opinion…

The Pain & Pleasure of Diversification

Dominic, June 12th, 2019

It is human nature to look at an investment that has done particularly well and wish you had been invested in it. We all risk being dragged into ‘if only’ mind games: ‘If only I had put a £10,000 into Amazon in 2003, I’d be retired by now’.  ‘If only I had bought Bitcoin at £1…’. These thoughts are dangerous to investors, as this fear of missing out (FOMO) can tempt them into taking speculative risks, often based on a rear-view mirror perspective. Concentrated risks have concentrated outcomes, both good and bad.

Read More
Enjoy yourself!

Jonathan, June 5th, 2019

The world of financial planning can be complex and technical. It's sometimes easy to lose sight of why having a financial plan is so important! We recently came across this amazing video of Doris Day, singing in the 1950's and felt it was an apt reminder of what we're trying to achieve in the Expert Wealth family. Have a look!

Read More
From early July we’ll be recording all incoming calls

Dominic, June 4th, 2019

At Expert Wealth, we're always looking for ways to improve the standard of service we offer. We would like to inform you we will begin recording all incoming calls to Expert Wealth from the end of June 2019. This will allow us to monitor the quality of service we're offering on the phone, and give you all the same security you would have when you're meeting us face to face in the office.

Read More
T: 01993 772467      E: advice@expertwealth.co.uk

Expert Wealth Management, West Wing, The Old Dairy, High Cogges Farm, Witney, Oxfordshire, OX29 6UN


Your Protection: In the unlikely event of your ever having a complaint which we have not been able to resolve amicably, you have recourse to the Financial Ombudsman Service (FOS). This is an independent body which will investigate complaints at no cost to you.  The FOS website is www.financial-ombudsman.org.uk.