Choosing what to do at retirement, buying that pension annuity, choosing the right options, is one of the most important decisions you’ll ever make. Make the wrong move, buy the wrong pension annuity and the wrong options, and you could be tens of thousands of pounds worse off. Yet millions fail to shop around for the best deal. Most people use their pension savings at retirement to buy an annuity. But these do come in all shapes and sizes: 

Level Annuity (single life). The vast majority of people prefer the security of an annuity which pays a guaranteed income for life. Current rules mean most people with personal pension savings have to buy one by the time they reach 75. The most popular option is a level annuity which pays a fixed income. There is a massive difference between the best and the worst rates. A £50,000 pension pot will give a single man aged 65 income of £3,903 per year from Aegon - which has the best rates at the moment. You’ll get just £3,219 a year from Axa, which pays one of the worst incomes. If you want to guarantee the payment for five years, you’ll get £3,878 from Aegon at age 65.

Level annuity (joint life). You can ensure some or all of the money passes to your spouse if you die by buying a joint life annuity. The trade-off is you get a slightly lower income from the start. Aegon currently has the best deal, at £3,585 for a £50,000 investment.
Enhanced/Impaired. If you have certain medical conditions or are a smoker, you could qualify for a better pension in the form of an enhanced - or impaired - annuity. These boost your retirement income - basically because your reduced life expectancy means your pension pot is spread over fewer years.

Inflation-linked annuities. Similar to level annuities, but your income grows in line with inflation - the Retail Prices Index.

There are are other options if you’re prepared to take more risk and have a bigger pension pot. These include with-profits annuities and variable annuities - both of which are linked to the stock market. These can pay a higher income, but can also give out less if the stock market falls. You should watch out for higher charges, particularly with variable annuities. These pay you a percentage of the value of your fund as income - typically 5%. 

Trevor Newham: I am coming to retirement and have a pension with a leading insurance company, Standard Life, with a pension pot of around £240,000. They are offering me an annuity but a good friend has suggested I shop around, using something called the open market option. I am 65 years of age and smoke, which is no doubt a problem. I don’t understand the position. Can you help, please?

Trevor’s friend is quite right. You are not compelled to accept the annuity offered by your pension plan provider, normally as in this case an insurance company, and you should shop around on the open market to see if you can get a better deal for your money.

What this means in practice is either yourself or using the services of an independent financial adviser (IFA) ringing or writing to other annuity providers and asking them for a quote which you can then compare with that which the company which you have used to save up for your pension is offering you. It is a fact that for whatever reason many people don’t do this and can lose out substantially in consequence.

Remember that signing up for your annuity is a once and for all decision. It is important to choose the right type of annuity - there are many different types not all of which will necessarily be right for you - and get the best deal possible. You will not be allowed to change later on even if you think you have got it badly wrong. Being a smoker won’t be a problem - it might even be an advantage in that you might qualify for a higher rate because of that fact.

Because this is quite a complicated area the Pensions Advisory Service (TPAS) has produced a free and fairly simple to use Annuity Planner, a web based tool to help people with the important choices and decisions they have to make when as in Trevor’s case they are approaching retirement and need to turn their pension saving into an annuity

Enhanced and impaired life annuities are for people with medical or lifestyle conditions, and for those who smoke regularly. They can be significantly higher than standard annuities. Four out of ten people qualify for these higher paying annuities and quotations should be requested. The extra income could be up to one-third more than a standard annuity.

Enhanced and impaired life annuities are designed for people with medical or lifestyle conditions that can potentially reduce life expectancy. Finding out whether you might qualify is easier than you might think. Three simple questions to be answered:

1. Do you smoke?
2. Do you now or have you ever taken prescription medication?
3. Have you ever been hospitalised for a medical condition?

What to do next?

If you answer “yes” to any of the three questions above, you will need to provide details for an accurate annuity rate to be calculated.

Medical conditions that may qualify include: cancer,  heart conditions,  diabetes,  asthma,  obesity,  high blood pressure,  organ transplants,  stroke,  liver disease,  alzheimer’s,  chronic lung disease,  kidney disease,  multiple sclerosis,  Parkinson’s Disease,  or a disease of the central nervous system.

However, this is not a comprehensive list so it is worth checking if specific medical conditions are included.

Remember, enhanced and impaired life annuities are not only for people with serious medical conditions. Lifestyle conditions such as high blood pressure, high cholesterol and diabetes (insulin dependent) could qualify for enhancement on their own or in combination. In fact, over 1,500 medical and lifestyle conditions could count.

Some good news if you can’t quit smoking; your addiction to nicotine will actually benefit you if you are buying an annuity. This is because insurers pay higher annuity rates to smokers because they have a shorter life expectancy than non-smokers. When it comes to annuities, insurers will class you as a smoker if you have smoked at least 10 cigarettes a day for 10 years.

If you smoke 10 or more cigarettes a day, suffer from diabetes or a terminal illness, you could be entitled to add as much as one-third to your annuity by buying an enhanced annuity.

People are often reticent about admitting to smoking when they are buying an annuity, thinking that it will count against them. But in fact, the effect is the exact opposite of when you are buying life assurance, so smokers should be sure to declare their habit to their financial adviser.

Take Mr. W, from Wales. He has given up smoking for almost a year and is currently shopping around for life insurance. He says: “I started smoking when I was really young, about 11 or 12, and although I gave up about five years ago a few personal issues meant I ended up starting smoking again. But when the ban came into effect last summer it got harder to smoke in a lot of places such as the pub so I decided to give up again. I also wanted to get more healthy.”

“Last year when I was looking for life insurance and critical illness cover it was too expensive for me, about £60 a month,” he says. “But because I’ll be classed as a non-smoker when I haven’t smoked for a year I’ve started looking round again.” He found cover for £35 a month.

Then we have Mr. V, again from Wales, aged 62, and a smoker. He got an annuity quote without giving details about smoking, and was quoted £5202 per year. A friend suggested he disclosed his habit. He did, and was quoted £5814 per year. Now he can afford the cigarettes, or perhaps he should now give up smoking.

Annuity rates vary widely across the market. In some cases, the difference between the highest and lowest annuity rates can be more than 14 per cent for someone in good health. For those in poorer health the difference between the best standard annuity and an enhanced or impaired life annuity could be a further 23 per cent. Working this through, this could be more than 41 per cent above the lowest standard rate.

A 65-year-old receiving a standard annuity of £500 per month could be receiving an income of £705 per month if he qualifies for an enhanced annuity. This would equate to £39,360 extra income if he were to survive for 16 years (the average life expectancy of a 65-year-old male according to the Government Actuary’s Department).

However, most people leave their pension money with the insurer with which they saved for their pension before retirement. So now we have a whole host of new providers starting to capitalise on impaired and enhanced annuities.

Arguably, if you are a smoker, have high blood pressure, are overweight or have high cholesterol then the odds of getting a better annuity rate are significantly higher. Becoming a 40-a-day smoker and living off take-away food may get you a higher annuity, but the chances are you will spend the extra you get and significantly more on funding your new lifestyle.

It has long been estimated that 40 per cent of people at retirement could qualify for some form of enhanced or impaired life annuity – based on the fact that 27 per cent of people in the UK smoke and 22 per cent are obese.

Add to this the number of people who have, or have had, some form of heart or lung disease or diabetes, and it is clear there is a substantial opportunity for many people to improve their income. Yet only about 10 per cent of people actually take out enhanced annuities.

Annuities are guaranteed, a rare quality in financial services these days. If you worry about your pension fund then it may be time to buy an annuity – but make sure you check to see if you qualify for an impaired annuity.