Which kind of annuity should I buy?

When taking pension benefits, most people buy an annuity. This is the process of exchanging a pension fund for an ‘income for life’. Jeff Miller explains.

Buying an annuity is essentially the process of exchanging a pension fund for an ‘income for life’.  Annuities come in many different shapes and sizes, and the buyer will need to make some key decisions.  Unfortunately, these decisions cannot be unmade, due to the nature of these contracts, so it’s important to get it right.

One of these decisions is whether to buy a level annuity, which pays a level income for life. Or to buy an escalating annuity, which will escalate or increase each year for life.  Not surprisingly, an escalating annuity is considerably more expensive than a level annuity.  Or to put another way, with an escalating annuity the income will be considerably lower for a given size of pension fund, when compared with a level annuity.

Mr. Average

As an example of the relative costs involved, let us consider Mr Average who is about to retire at the age of 65.  According to the latest UK Interim Life Tables, Mr Average can expect to live for another 17.8 years.  He has a pension fund of £80,000, and wants to take the maximum tax-free cash when he retires.  This is £20,000, which leaves a fund of £60,000 with which to buy an annuity.

His £60,000 will buy the following:-

Annuity, level:  £3,402 p.a.
Annuity, escalating at 3 per cent p.a:  £2,367 p.a.*

The reduction in initial income when choosing an annuity that escalates at 3 per cent p.a. is £1,035, a full 30 per cent.

Even without adjusting for inflation and the benefit of having more income earlier, Mr Average would need to survive for more than 24 years before the escalating annuity produced more in total income received.

After adjusting for inflation at 3 per cent p.a., Mr Average would need to survive for more than 27 years to be better off with an escalating annuity.  This is 50 per cent longer than the average 65 year old male actually does survive.

On balance, unless you expect to live for 50 per cent longer than average, a level annuity is likely to prove the most cost-effective option.

• Learn more about annuities and the sort of questions you should ask

*Source: MAS 30/05/2013. Male 65. Monthly in arrears.