With all the excitement over unsecured pensions (what we used to call income drawdown) and alternatively secured pensions (available from age 75 but with strings attached) it can be all too easy to forget about the basic annuity.

Annuities offer two great advantages over the alternatives – they are guaranteed and they are relatively low cost. On the other hand, they are generally inflexible and – with interest rates at an historic low, as well as continually rising life expectancy – not particularly generous.

There is one other aspect about pensions that makes individual advice absolutely essential. They almost always involve an irreversible decision. In this article we will ignore issues about tax free cash and the more modern alternatives and get ‘back to basics’ with annuities.

What is an annuity?
An annuity is a promise given by an insurance company that it will, in return for a single lump sum from you (usually, but not always from a pension scheme), pay you an agreed income for the rest of your life (or in some cases for a fixed period).

There are some variations to the basic annuity and this is where the decisions come in.

What are the basic choices?
The first thing to decide is whether you require a level or increasing income. In the latter case, the increase can be at a fixed rate – perhaps at 3% or 5% a year – or in line with RPI inflation.

An increasing income may sound attractive, but you have to be aware that this will mean starting off with a lower income than in the case of a non-increasing one. The difference can be as great as 25% or more. As can be seen from the chart, based on 3% p.a. increases, the income is actually smaller for more than ten years; and it takes a further decade for the accumulated deficit to be made up.

What else do you have to think about?
The second decision that needs to be made is whether a single life annuity or one that carries on until the second of two lives dies is required. In the latter case, should the income carry on at the same level on the ‘first death’ or reduce by 50%?

The ‘cost’ of a joint life annuity is less than an indexed one, with a reduction in income of just 8% for a second life of the same age (in this example 65) if the income is halved on the first death or a reduction of 15% if the income remains the same on the first death.

With profit annuities
A slightly more recent innovation is the with profit annuity, where the level of income is linked to stock market investments and can fall as well as rise. This clearly involves an element of risk, but perhaps without the increased flexibility of the unsecured pension.

For many people, particularly those with a relatively modest pension fund or no alternative sources of income, annuity purchase may remain a good option. For those with larger funds, alternatives can be considered.

It is important always to seek individual professional advice before making any decision relating to your personal finances.

NOTHING CONTAINED IN THE ARTICLE SHOULD BE CONSIDERED AS GIVING INDIVIDUAL FINANCIAL ADVICE. PLEASE NOTE THAT THERE MAY BE VARIATIONS FOR THOSE LIVING IN SCOTLAND AND NORTHERN IRELAND.