Don't retire hurt: get a better annuity

You can make a huge difference to your pension income if you shop around

The popularity of annuities - the guaranteed income for life that pensioners receive from an insurance company on payment of a capital sum - is at rock bottom. Low inflation, which brings lower investment returns, is resulting in a poor deal for pensioners.

The popularity of annuities - the guaranteed income for life that pensioners receive from an insurance company on payment of a capital sum - is at rock bottom. Low inflation, which brings lower investment returns, is resulting in a poor deal for pensioners.

Even so, we are still obliged to buy a lifetime annuity by the time we are 75, so it is important to shop around for the best deal. Yet many retirees don't.

"It is staggering the number of people who don't realise that they can shop around," says Stephen Brady, at independent financial adviser, Chartwell Investment. "The life companies say 'here is our rate' and people just take it. For the sake of making a few phone calls, you can significantly increase your pension income for life."

According to Mori, of those familiar with the term "annuity", only 55 per cent know the product can be bought from any company offering it. Investors who do not exploit this can be left with annuity payments significantly lower than what they could have received.

For example, a 60-year-old male with a sum of £10,000 can purchase an annuity from NPI worth £692 a year. If he shopped around and chose Scottish Widows or Legal & General instead, he would have received £757 or £815 respectively.

Annuities represent one of the few cases where being overweight or a smoker is beneficial financially - as such you would get enhanced rates. Using the same criteria, a regular smoker could obtain a payment of £836 a year, an improvement of more than 20 per cent on the original NPI quote.

Annuity rates have been falling for the past 10 years because conventional rates are tied to 15-year gilt yields, which have collapsed from a high of 12.4 per cent in 1990 to around 5 per cent today. The outlook for annuity rates remains bleak, not least because people are living longer: in the 1950s, the average 60-year-old male could expect to live for another 10 years; today it is 25 years.

A fixed-rate annuity may be tolerable over 10 years, but over 20 to 30 years, inflation can seriously erode the income. Specialists in the field therefore recommend investment-linked annuities to protect the retirement income.

An investment-linked annuity is tied to a with-profits or unit-linked fund, rather than to gilts, so that the pension fund can continue to grow. A with-profits annuity invests in the insurer's with-profits fund, a mix of equity, property and fixed interest investments.

There is plenty of choice on the market compared with a year ago when only three with-profits annuity providers existed - Equitable Life, Scottish Widows and Prudential. Now, Norwich Union, Scottish Mutual, Axa Sun Life, Legal & General and Standard Life all offer with-profits annuities.

Investors must select an assumed bonus rate (ABR) of up to 5 per cent, which is normally, but not always, fixed for life. Changes in yearly annuity payments are based on the difference between the ABR and the actual bonus paid. So if you chose a low ABR of 3 per cent, but a bonus of 8 per cent was paid, you would get an increase in income the next year of about 5 per cent. If the reverse happened, your income would fall.

Norwich Union guarantees that its with-profits annuity payments will never fall below what you would have received from a 0 per cent ABR. It also allows for a joint life annuity (on the death of the first annuitant) to be converted into a conventional annuity. This gives the surviving spouse peace of mind that payments will not fluctuate.

Prudential offers a similar conversion option. The Standard Life annuity lets you alter the ABR at any time after the first anniversary of the policy. The first three changes are free, but subsequent changes carry a charge. Standard Life also guarantees that your income will not drop more than 10 per cent from the previous year.

Canada Life is offering an Annuity Growth Account which includes some features of both a unit-linked annuity and income drawdown, but it is treated as an annuity by the Inland Revenue. It allows you to use part of your pension fund to buy temporary five-year guaranteed annuities until you reach the age of 85, while keeping the remainder of the fund invested in equity-linked funds.

Under income drawdown rules, a lifetime annuity must be purchased before you are 75, while an Annuity Growth Account allows you to defer until 85. This is because the remaining pension fund is seen as a deferred annuity fund, even though it is invested in equities.

After the first five-year annuity has expired, you can either buy another five-year temporary annuity or purchase a lifetime annuity.

Buying Canada Life's annuities in five-year chunks has three advantages. First, the bulk of your fund can remain invested in any of the company's 22 pension funds, which should boost the fund's value. Second, if annuity rates improve, you can lock into better rates after five years. Third, if your circumstances alter - such as your spouse dying - you can buy a single life annuity after five years instead of being locked into a joint life annuity for life.

"This is really innovative," says Ronnie Lymburn at the Annuity Bureau. "It allows people to have a decent income over five years and to then review what they want to do at five-yearly intervals until aged 85."

It is not difficult to shop around for the best quote: Chartwell has an annuity service, which does the legwork and allows investors to benefit from the commission that most annuity providers pay.

* Contacts: The Annuity Bureau, 020 7620 4090; Chartwell's Discount Annuity Service, 01225 321700.