There are a variety of options available to you with your pension annuity, the income in retirement you buy with your pension fund:
A single-level annuity is the simplest type of pension annuity. It pays out exactly the same amount to an individual (the “annuitant”) every month until the annuitant dies.

A guaranteed annuity pays out an annuity payment each month for at least the length of the guarantee period, even if the annuitant dies before the end of the guarantee period; in which case the guaranteed annuity payments are made into the annuitant’s estate. The maximum guarantee is ten years. Five years is quite common in practice.

With an inflation-linked annuity the annual payments increase by the rate of increase in the Retail Prices Index (RPI) to give payments protection against inflation.

With an escalating annuity the annual payments increase by say 3 or 5 per cent to give the pensioner some protection against inflation and to allow for possible increased income needs as the annuitant ages.

Joint-life or last-survivor annuities pay an agreed annuity payment to an annuitant and the annuitant’s partner while both are alive. Following the death of the annuitant the contract pays either the same amount or an agreed reduced amount each month until the partner dies. The reduction in last-survivor annuities is typically a half to one third.

Investment-linked annuities involve the fund backing the pension annuity being invested in an equity product. The annuitant receives an annuity payment that is related to the performance of the equity market.

An impaired-life annuity pays an increased annuity payment if the annuitant has health problems, such as cancer, chronic asthma, diabetes, heart attack, high blood pressure, kidney failure, multiple sclerosis or stroke.

An enhanced annuity pays a higher annuity payment related to actuarial considerations.

Phased-retirement or staggered-vesting annuities. With these, instead of converting the whole pension fund, withdrawals are scheduled over several years. This is achieved by splitting the fund into many separate segments.

A with-profits annuity links income directly to the performance of the insurance company’s with profits fund. Typically, income is made up of two parts: a minimum starting income and bonuses.

A short-term annuity allows an individual before 75 to use part of a pension fund to buy a fixed-term annuity lasting up to five years. They can choose annuity options in much the same way as basic annuities.

Value-protected annuities pay a lump sum on the death of the annuitant, equivalent to the difference between the original purchase price and total payments made. The lump sum is taxed at 35 per cent. They are only available until aged 75.

With so many choices it is wise to seek out specialist advice when buying your pension annuity.

Here we consider the benefits of pension annuities and why income drawdown should be approached with caution. There really is no argument to suggest that income drawdown will eventually replace pension annuities, although there is a role for income drawdown and variable annuities for the right customer at the right time.

Let’s consider annuitisation. It can work within pension annuities invested in unitised funds thereby enabling a higher lifetime income in exchange for giving up capital on death. There is therefore no suggestion that income drawdown will replace pension annuities simply because drawdown can invest in equities and enjoy the benefit of the equity risk premium.

The critical difference between annuities and drawdown is the impact that annuitisation has on the trade-off between income and death benefits. Higher death benefits result in lower income and vice versa - you can’t magic something out of nothing or magic the risk away.

One major reason why drawdown will not replace annuities is the size of pension funds. Too many are too small; over 75% of current funds are less than £30,000 after the 25% tax free cash has been taken. 

Hopefully, fund sizes will increase significantly in the future and this may lead to higher drawdown take up. But there are always going to be a lot of pensioners with insufficient funds to be able to afford the drawdown route, and who will get better value from buying a new generation pension annuity product.

With the increasing longevity we are witnessing one major pension annuity provider, Legal & General, is predicting an increasing demand for their with profit annuity contract. They believe independent financial advisers (IFA’s) will see this contract as an alternative to conventional annuities where the retiree is prepared to accept a degree of risk.

They might have a point, but we are seeing turbulent stockmarkets around the world, and this does, and will, have an effect on the performance of with profits funds linked to this form of pension annuity. A significant downturn can have a dramatic effect on future income from this form of pension annuity. There are no guarantees on performance.

To help, L&G has produced a guide to the products for advisers to use with their clients, which includes a calculator to estimate the potential impact of inflation on income.

Head of annuity product development for L&G’s individual annuity business Tim Gosden says: “People may have to rely on their pension for 20 years or more. This is a long time to live on a fixed level of income provided by a conventional annuity, particularly given the likely impact of economic changes over that period. Exposed to the ravages of inflation, a customer’s pension income could soon become insufficient to cover increases in the cost of living.”

L&G says that even during a period of low investment returns, the income from a with-profits annuity will not fall below the minimum guaranteed level set at the outset, although additional investment returns are not guaranteed so this presents a degree of risk. All this means is that the retiree has to be careful, and understand the risk involved related to future performance and income.

But L&G says the effect of smoothing means that in turbulent market conditions income stream is less susceptible to dramatic fluctuations in value.

A with profits annuity. This is an annuity product where policyholders can receive an income linked to a strong with-profits fund, providing them with the further potential to receive additional income not possible under a conventional annuity. So retirees can potentially benefit from the increased returns available from stockmarket returns, while still guaranteeing a base level of income.

However, with-profits annuities can be tarred with the same brush as some other with-profit-based products from certain providers. Even accepting this, with-profit annuities are the right choice for some who are looking for an increasing retirement income, and what this really highlights is the need for professional independent advice when planning for and approaching retirement.

Despite over 50s admitting that they are more worried than ever about their financial situation as they approach retirement, the LV=, a leading pension annuity provider, State of Retirement Report revealed that more than half (56%) of this pre-retired group have yet to seek professional financial advice at all about their overall financial situation. This majority equates to 5.5 million people across the UK, indicating a real opportunity for financial advisers.

There also seems to be a gap between what people discuss with financial advisers and perhaps what their actual needs might be. Of those over 50s who have already consulted a professional about financial advice, ISAs are the most popular topic, with 43% of this age group discussing ISAs, followed by low risk investments (30%), general pension planning (28%), and inheritance tax planning (20%).

Legal & General believes that with profits annuities will become more interesting to advisers as an option to conventional annuities, especially with improvements in longevity, for those customers who are prepared to accept an element of risk. A with profits annuity offers customers the opportunity of security, in the form of a guaranteed minimum level of income, and also provides the opportunity for income growth. So as longevity improves, the investment potential offered by a with profits annuity may help to counter the impact of inflation on pension income over the longer years of retirement.

Tim Gosden, head of annuity product development for Legal & General’s individual annuities business said; “People do not appreciate how long they are likely to live in retirement. They may have to rely on their pension for 20 years or more. This is a long time to live on a fixed level of income provided by a conventional annuity for example, particularly given the likely impact of economic changes over that period. Exposed to the ravages of inflation, a customer’s pension income could soon become insufficient to cover increases in the cost of living. Even during a period of low investment returns, the income from a with profits annuity would still not fall below the minimum guaranteed level set at the outset.”

With profits annuities may appear more complicated than conventional annuities but the underlying concept is straight forward.