A beginner’s guide to annuities

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Annuities haven’t got a very good name at the moment. They are blamed for many problems which are not their fault. One problem with annuities is that most people don’t understand them! Another problem with annuities is that people have bought them carelessly without understanding what they have bought. A third problem with annuities is that they are solving a problem that most people don’t recognise exists, that most people are going to live a lot longer than they bargain for.

The annuities I am going to talk about in this article do a very simple job, they are called “purchased life annuities”, because you buy them for the rest of your life! The deal is this, an insurance company takes a view on how long you are going to live and then works out a sum of money it is going to have to put aside to guarantee it will pay you this amount till you die. It then tells you how much it needs from you to pay you an income.

So supposing I am 60 years old and a man and in pretty good health, the insurance company might work out that I can be expected to live another 30 years, and if I want the money to be paid to my wife after I died, 35 years. For every £1000 p.a. that I want paid me, the insurance company might demand £30,000 from me, being the amount they expect to pay-out. Except it won’t cost them that much as they can get interest on the money I give them which can go some way to offsetting the cost to them of the guaranteed promise. So they might discount that £30,000 to £20,000, reckoning they can get the rest in interest. This is how insurance companies “price annuities”.

Now there are all kinds of wrinkles that effect the price. Your state of health for a start, the insurer should be looking at whether you have an unhealthy lifestyle (smoking, drinking etc.) ,whether you have a history of early death in the family and whether you have any medical conditions that make you likely to die sooner than the average. All of this will bring down the cost of paying you your £1000pa. The insurer can tell a lot from where you live (some Chelsea postcodes have a 17 year longer life-expectancy for residents than some postcodes in Tottenham! And it’s nothing to do with football!).

And as well as health, there’s the question of what you mean by “£1,000”. If you want that £1,000 to keep pace with inflation – then it’s going to cost more. If you think inflation will be 3%pa it might cost 15% more to link that £1000 to inflation, but if you think it will run at 5%, that 15% could go up to 25% more. And this uncertainty makes it even more expensive, because the insurance company has to put money by in case inflation is 7% or even 10%. This process of “putting money by” or “reserving” as insurers call it, is a menace! There are a stack of EU rules about reserving that are designed to make sure an insurance company does not go bust, the trouble is that they mean the cost of an annuity is a lot higher. The extra security of UK annuities makes them almost 20% more expensive than the equivalent America product.

UK Annuities are amongst the most regulated and therefore among the safest ways of investing your money, you can find anywhere on the planet. The trouble is that that safety comes at a price. People considering buying an annuity need to consider whether they want to pay that price and make absolutely sure they get the price down by fully declaring all their medical problems to encourage insurers to drop their prices. People buying an annuity should take quotes from every insurer in the market and they should think long and hard about whether it’s right that the annuity ends with them or whether a spouse, partner and even the kids need some protection if they die early.

As you’ve probably worked out for yourself right now, buying an annuity, like buying a house of a business is not something you do without taking good advice. Many people will need help not just working out what kind of annuity to buy , but when to buy it. You may not need the guarantees now, when you are relatively young, but in ten or fifteen years’ time, things may be different.

So if you’re a beginner- don’t buy an annuity. The people who should be buying an annuity should be experts! A good adviser can make you an expert, you can make an expert of yourself, but if you use your pension pot to buy an annuity and take the first offer that comes your way, more fool you!

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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1 Response to A beginner’s guide to annuities

  1. Jeremy Stevens says:

    Hi Henry. An annuity is a means to an end; it provides peace of mind that you will receive an income until you die and if you want to look after a spouse or dependant, income until they die as well. And/or, income for a minimum period of time if you both die. The question then becomes one of ‘how much are you willing to pay for that peace of mind?’ If you want an annual income of £1,000, with £500 being paid to your spouse if you die before them, with a guaranteed income period of 10 years if both of you die before 10 years is up, then what are you willing to pay £30,000 of your pension fund to achieve this?

    You’re right, the mechanics of how insurance companies decide the price of the annuity is not well understood, but there are so many factors priced in that it’s difficult for anyone other than an actuary to understand them fully!

    One thing I would point out is the disparity between the number of people that get an enhanced rate based on their health/occupation/postcode etc., depending on whether they get advice or not – c70% of people who buy an annuity via an adviser, using the open market option, get an enhanced rate, whereas only c10% of those who just roll over into an annuity with their existing provider get an enhanced rate. Shop around people, get the best rate you can!

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