It's still a gamble when you cash in the chips

You've built up a pension and wish to draw an income. Simon Read explains the ins and outs of buying an annuity

Hands up all those who can say they understand how their pension operates. And how many of those who know the answer do not earn their living in the pensions industry? The reason why so few of us have done our homework is that pensions are boring to most people under 40. However, they appear more complicated than they really are.

Traditional occupational pensions are simple. Money is taken out of your pay every month, the company adds more, and when you retire your pension is based on a fraction of your final salary for every year of service.

Personal pensions and new-style money purchase company schemes work in a different way. Your contributions are invested in your personal fund and on retirement you can take some in cash but most is used to provide your retirement income through an annuity.

That leads us straight to the next question: what is an annuity pension and how does it work? Annuities are fairly simple to understand. It is the maths behind them that is complicated. How much income your annuity pays out depends on a number of factors, which is why they often confuse people. To add to this confusion one annuity cannot always be compared directly with another as the rates are reached by actuaries whose methods are not always consistent with each other.

You can think of an annuity as a back-to-front insurance policy. Insurance is basically a gamble against an event happening, whether it is your house being burnt down, your car stolen, or you needing hospital treatment. You place your bet when you pay the premium and if the event happens the insurer pays out. The cost is governed by the odds against the event happening and the cost of putting it right. An annuity works the other way round. You pay the lump sum at the beginning to receive a regular income for the rest of your life. To work out how much income to pay, the insurers are gambling on how long you live. So the older you are, and presumably the shorter your life expectancy, the higher income you will get from your annuity. Men will also receive a higher income than women because their life expectancy is shorter, while smokers and the overweight can do even better. The interest rates paid on annuities vary from day to day. In the past this could have meant that if you retired on the wrong day, you could end up with a low income as the interest rate is fixed for the term of the annuity. Recent changes in legislation have, however, altered that and you are now allowed to defer buying an annuity until you reach the age of 75, drawing from your pension fund through an "income drawdown" scheme.

The main advantage of an income drawdown scheme is that if you die your pension fund can be inherited by your spouse or dependants. If you bought an annuity and then died there would be nothing to pass on; the annuity benefits die with you. Arriving at the right strategy to get a good- sized retirement income is not easy and expert advice can help. An independent financial adviser can pick out appropriate funds and explain how to get the best from your annuity. As always, however, when dealing with experts be aware that their advice is not free.