Don't short-change your loved ones by choosing the wrong annuity

Some pension options could leave spouses in trouble

More than half of adults in their forties risk losing their entire pension upon death and leaving their loved one stranded, according to new research from insurer Prudential.

In addition, the study found that 39 per cent of couples have nothing in place to ensure that their income will continue be paid if one partner dies, and a further 13 per cent simply have no idea what will happen to their pension and other investments if their partner dies. In many cases, this is simply down to a lack of understanding about the various options available.

"People might never discuss their annuity plans with their partner and are at risk of losing income, the classic example being that with annuity rates historically low, many people are opting for single life annuities which offer a higher initial income but can lead to difficulties later on," says Vince Smith-Hughes, head of pensions development at Prudential.

This is a particular problem for women because men tend to have larger pensions and are statistically likely to die first. With more men taking out a single life annuity without being fully aware of the consequences, this could leave many women in dire financial straits on the death of their husband. More often than not, investors stick with a standard annuity because they are attracted by the elevated income from the outset. With joint life annuities the payout is reduced because the provider is more likely to make payments for longer. Others simply haven't looked beyond what is offered by their pension provider.

"People often go for the easiest option but this is not necessarily the best," says David Abbis from analysts Defaqto. "There are a lot of options with joint life annuities; you can have a sum guaranteed to pay for at least five years and choose what percentage is paid to your spouse on death."

If you do opt for a joint life annuity, you can typically choose whether the proportion that continues to be paid to your surviving spouse is 100 per cent, two-thirds or 50 per cent of the original pension value. If you choose a guarantee as well, your spouse will continue to receive your annuity income when you die for the rest of the guaranteed term (five or 10 years), then receive their own pension from then until the rest of their life. Also, if you're concerned about decreasing spending power, you can opt for an inflation-linked annuity.

You may prefer to look into income drawdown instead of an annuity. Heavy taxes currently compel most investors to buy an annuity at the age of 75, but these are set to change so that people are able to continue in drawdown as an alternative. With this you keep your pension invested and take an income directly from the fund when you need to, up to a maximum limit each year. This does carry the significant risk that the fund value will fall, but it will also allow you to benefit from increases and bypass poor annuity rates. If you die, your surviving spouse can then take over 100 per cent of the fund.

As well as missing out on the potential benefits of a joint life annuity, retirees also risk losing extra income if they fail to take out an impaired or enhanced annuity. These annuities provide an above-average monthly income if you have an illness or health condition that is considered likely to shorten your life. If you smoke, for example, or have a serious weight problem, you may be eligible for an enhanced annuity – in fact, there are more than 1,500 conditions that count towards an enhancement.

Only about one in 10 of the annuities bought each year are enhanced, but research from annuity specialist Just Retirement indicates that 56 per cent of people aged between 65 and 74 have a long-standing illness and could qualify for an enhanced rate. The potential increase is impressive; for example, a 65-year old male with a £60,000 pot could increase his annuity rate from £3,824 to £4,500 if he had diabetes for three to five years and was treated with medications. "Providers take different views on what might qualify, so it's worth your time to see if an enhancement is available. For just filling in a form you could increase your income for the rest of your days," says Mr Smith-Hughes.

Another mistake people make is to buy their annuity from their pension provider without looking for a better deal – known as taking the open market option. Also, if you have a larger pension pot you may be willing to take on more risk in the hope for a bigger income. A fixed-term annuity pays a guaranteed income for a set number of years, at which point you take out another policy. If annuity rates have increased or your health changes, you could get a bigger income, but you will get less if rates have fallen. Investment-linked annuities are another option and keeps your pension invested in the stock market, but again, this could rise as well as fall.

Beyond pensions, other ways to ensure your loved ones are catered for is to take out separate life insurance. "They could arrange separate life cover or use other savings such as ISAs that would be passed to the surviving spouse and generate an income," says Adrian Lowcock of IFA Bestinvest.

Expert View

Adrian Lowcock, Bestinvest

"Before retirement, make sure you have death benefit nominations in place so if something happens the surviving spouse gets the pension pot. Post-retirement or when drawing benefits, if you're buying an annuity and it is the only source of income or capital available, then it is usually worth buying a spouse's pension and or a guaranteed period."