Shop around to ensure a more comfortable life in retirement

Annuities have provided an income in retirement for generations but the options are now far more complicated than even a generation ago.

Four in 10 (42 per cent) have no idea what an annuity is, according to Sun Life Financial of Canada. A significant number of over 55-year-olds even thought it was insurance against unemployment.

In theory, annuities should be straightforward. A person saves through a pension during their working life with the incentive of tax relief (currently up to 255,000 a year with a lifetime allowance of 1.8m, which will reduce to 1.5m next year).

Upon retiring, the pension fund is converted into an annuity, guaranteeing an income for the rest of life with the additional potential to provide for a partner in the event of death.

Yet increased life expectancy, low interest rates and poor investment management have all taken their toll on the level of annuity offered. The average child born today can expect to live to 103.

Two years ago a 65-year-old man with a 100,000 pension could buy a level income of 7,855 a year. Today the same sum would pay only 6,520.

Yet the first lesson is to shop around – known as the 'open market option' – and not automatically take the offer made by your pension company. It may result in some real surprises. In the above example, the range for a level annual annuity varies from just 5,360 to 8,040.

Retirement experts are concerned about how few look at the alternative annuity offers.

It's vital that those entering retirement have good independent advice and protect themselves against the ravages of inflation. Currently money is being eroded at 4.7 per cent (retail prices).

There are several ways of tackling the spectre of inflation:

n an initial guarantee period such as five or 10 years;

n escalating at five per cent annually;

n linked to RPI;

n with-profits.

Unfortunately, such protection comes at a cost. Taking the same 65-year-old male with 100,000 pension, guaranteeing for five and 10 years produce annual annuities of 5,340-7,910 and 5,270-7,520, according to Moneyfacts Investment Life & Pensions.

A 'guarantee' means that if the applicant dies at any stage during the period, the insurance company will continue to pay out to their beneficiary. If level with no guarantee, even if death is one day after taking out the contract, no more money is paid which can make for an expensive gamble.

If instead an annuity is preferred which escalates at five per cent compound, the annual payment will be dramatically lower at 2,580-5,200, depending on the provider. If your preference is to opt for an annuity which adjusts with RPI, the payment is likely to be 3,260-5,750.

Instead of this approach, some prefer with-profits annuities which allow you to choose the amount of income to receive at the start by selecting an anticipated bonus rate, usually varying in steps of 0.5 per cent from zero to five per cent.

At each anniversary of the annuity purchase, an annual or reversionary bonus is declared and applied to your regular income after allowing for the bonus rate already selected. There may also be a temporary or top-up bonus which can vary according to the length of time the annuity has been in force. On the example given earlier, with an anticipated three per cent bonus rate, the annual range is 6,344-7,228.

The next complication is what provision is made for your partner. Joint life annuities can be on two bases:

n no reduction on first death;

n reducing by one-third on death of male life.

Taking level annuities (without guarantees or inflation protection), the example of a 65-year-old male and 60-year- old female would pay 4,040-5,910 with no reduction on first death but 4,410-6,510 in the second scenario. AXA and Just Retirement provide the lower and upper figures respectively in both cases.

For a no reduction on first death (regardless whether male or female) on a with-profits with a three per cent anticipated bonus basis, the annuity range will be 5,070 (LV=, formerly Liverpool Victoria) to 5,396 (Legal & General). This is for a 65-year- old male and 60-year-old female.

Rates for women are lower in all the categories outlined to reflect long er longevity.

Most smokers realise that they qualify for enhanced annuities, notably offered by Just Retirement, LV=, Partnership and Reliance Mutual.

However, often those who are eligible for 'impaired life' annuities do not appreciate their position. Some insurers will pay a higher income than usual because they calculate the payment period will be shorter.

Cancer, diabetes, kidney failure, stroke or a heart attack are among the conditions taken into account. They include Aviva (formerly Norwich Union), Canada Life, Just Retirement, MGM Advantage, Partnership and Scottish Widows. In addition to a wide medical range, LV= takes into account multiple sclerosis, chronic asthma and those who are overweight.

An enhancement may also apply on occupational grounds. B&CE Insurance provide better annuity rates for those retiring from the construction industry.

Annuities can also be purchased for cash, rather than through a pension. This might appeal when someone has a redundancy payment or divorce settlement.

There are under 200,000 such contracts and yet there is a major benefit which is little publicised: part of the repayment is regarded as 'return of capital' and therefore not subject to tax.

For 10,000, a 65-year-old male opting for an annuity with no guarantee and no inflation protection would annually receive 518 (Canada Life), 574 (Standard Life) or 614 (Aviva). If a smoker, this would jump to 701 and if both a smoker and 'impaired' to 725 (both with Just Retirement).

Taking the 701 payment, 498 would be considered 'return of capital' for the duration of the annuity. This equates to 71 per cent and shows some of the benefit of taking this approach.

From April, new rules mean that those with pension pots have more flexibility, removing the requirement to buy an annuity by age 75. Instead they can invest in funds which permit 'income drawdown'. For a proper comparison of the options, it is vital to consult an experienced IFA in the field.

n Contact: Moneyfacts Investment Life & Pensions 0845 1689 600.