There are lots of different kinds of annuity on the market, reflecting the many different ways people want to use the money they've built up in their pensions. A little like mortgage deals, there are products for those who want a fixed, predictable income, and others for those want a deal that may go up or down, depending on investment performance or the rate of inflation.
The most important thing to remember is that currently, there's no way to change an annuity once you've bought one – so it's vital to choose the right one. Spend plenty of time shopping around and reviewing all of your options, and consider consulting a financial advisor before making your decision.
Below are some of the most common types of annuities and how they work:
Lifetime annuities. These are the most common types of annuity, and they essentially give you a guaranteed income for life, at a rate based on your life expectancy and the state of your health. There are a few subtypes of lifetime annuity:
Level annuities pay out a flat amount of income each year. Bear in mind that due to inflation, the purchasing power of your income will go down over the years – however, level annuities do usually offer the best income at the start of the deal.
Escalating annuities tend to offer a much lower starting income, but they pay out more each year – either by a set percentage, or in line with inflation as defined by the Retail Prices
Index. They may end up paying more than a level annuity if you live for a long time.
Single life annuities pay income only to you, and tend to pay a higher level of income than joint annuities. They're usually bought by people who are single in retirement, or who do not expect their partner to outlive them.
Joint life annuities pay income to you at first, and when you pass away, the income will pass on to your partner for the rest of their lives. This may be the full amount of the income, or a pre-decided percentage of it.
These are similar to lifetime annuities, but they offer higher rates if you meet certain criteria, normally regarding your health. People who smoke or have high blood pressure may qualify for an enhanced annuity, as can people with chronic illnesses such as diabetes, heart disease, kidney failure or cancer. Asthma, obesity and arthritis may also qualify you for these products, depending on their severity.
Enhanced annuities usually offer higher rates, because the annuity holder is not expected to live as long as a healthy person. This is why a financial adviser will ask questions about your health and lifestyle habits when you discuss annuities with them.
They are not offered by all providers, so if you think you may qualify for one, it is worth shopping around for one that does.
While lifetime annuities provide a guaranteed income until you pass away, temporary or fixed-term annuities pay out for a set amount of time (for instance, ten years) or until you die, whichever comes sooner. When the term is up, they also pay a "guaranteed maturity amount", which can be used to buy another annuity if you want to.
They can offer flexibility, as you are free to shop around for another deal when the term completes. However, there is also a risk that the maturity amount won't be enough to cover the rest of your retirement – for instance, if annuity rates fall or the rate of inflation rises during the period of the deal.
Like lifetime annuities, they can be bought in single, joint, level or escalating types.
Instead of providing a set amount, an investment-linked annuity provides income based on the performance of investments made by the provider. This means the income you receive could go up or down during the course of the deal, but there is always a guaranteed minimum income that you will receive.
There are two main types of investment-linked annuity:
With-profits annuities are linked to the performance of the provider's with-profits fund – these normally give a return linked to the overall performance of the stock market, rather than individual shares.
Unit-linked annuities are linked to the performance of funds that you invest in yourself, in a similar way to how stocks and shares ISAs work.
Investment-linked annuities always carry a risk. It's recommended to consult a financial adviser if you are considering one.
Purchased life annuities
Purchased life annuities work in much the same way as any other kind of annuity, with one major difference: you don't buy them with your pension fund, but with any other source of cash you have. However, you can use a lump sum taken out of your pension to fund a purchased life annuity.
The income from purchased life annuities also tends to be higher, as they are treated differently by the taxman. Because this income is considered to be a return of your own capital, only the interest element is taxed at your marginal rate, instead of all of it.