When buying an Annuity you have a number of sometimes bewildering choices. Should income be paid monthly or yearly, in advance or in arrears? What is a guarantee period? Do I need one? How much income does my spouse need if I die before they do?

As well as finding the best Annuity rate, all these decisions need to be made in the knowledge that once you have bought your Annuity it can never be changed.

It is fair to say that the more options you add on to your Annuity the lower the starting income will be. But just what does each option mean and how much does it cost?

Costs v Benefits

Escalation, a guarantee period and a spouse’s pension are the three most popular options we see being added to an Annuity.

We’ve carried out some research and found these interesting facts about the cost of each option:

• A guarantee period is the option which costs the least to add

• Including a pension for your spouse is the next cheapest option and would have the effect of reducing your starting income by approximately 10% per annum

• The option with the largest cost is escalation

Our research shows that whilst cost is an important issue when deciding on the shape of your Annuity, it is far from the whole story. For many people their Annuity makes up a significant proportion of their retirement income and it is vital to focus as not only on cost but also the shape of the Annuity to ensure it is durable over the years to come.

So, what are all these options and how much do they cost? We have summarised our findings here, but if you want answers specific to your situation we would suggest you consult and IFA or use a pension annuity calculator.

Payment frequency

Annuity payments can be made monthly, quarterly, or annually and you must choose whether you receive your payments in advance i.e. at the start of a period or in arrears i.e. at the end of a period.

Having income paid monthly in advance reduces the starting income by just over 3% for a male aged 65 and by just under 3% for a female of the same age.

Guarantee Period

Simply put, an Annuity will pay out for the rest of your life or indeed the rest of your spouse’s life if they outlive you if you have included a spouse’s pension. However, a guarantee period will ensure that income is paid for a minimum period of either five or 10 years if you and your spouse (if a spouse’s pension is applicable) die in the early years of the Annuity being in place.

A guarantee period of either five or 10 years can be added to an Annuity. As most people will statistically live longer than these periods the cost of adding in such a benefit is small.

For a man aged 65 and wanting his income to be paid monthly in arrears the starting income will be reduced by around 4% if a five year guarantee period is selected, this rises to 5.5% if a 10 year guarantee is preferred. For a woman the figures are 3.29% and 4.45% respectively.

Spouse’s pension

A spouse’s pension ensures that the income from the Annuity continues to your spouse after your death.

If a spouse’s pension is included you also have to decide at what level the income will continue to your spouse after your death, the most commonly selected levels are at 50%, two thirds or 100% of the starting income.

For a man aged 65, assuming his wife is 63 and the income is paid monthly in advance adding a two thirds spouses pension would reduce the starting income by around 13%, a 50% spouse’s pension would reduce the starting income by just over 10%.

For a woman aged 65, assuming her husband is three years older the reduction would be approximately 10% for a two thirds spouses pension and 8% for a 50% on-going pension.

Escalation

Simply put, adding escalation into an Annuity means it will rise each year. If this option is selected the annual increase could be a set percentage or in line with an index, usually RPI (Retail Prices Index).

This option is the most expensive, however it should be considered as it will help to maintain the buying power of your income.

For a male aged 65 adding and annual RPI increase to an Annuity paid monthly in advance would reduce the starting income by around 39%, if a 5% annual increase were selected this figure rises to just over 45%.

For a woman aged 65, who also wants income paid monthly in advance, the reduction on the starting level if RPI is added in is just over 41% rising to around 48% if an escalation rate of 5% is selected.

The all important small print

For the purposes the figures in this article we have used the income that the top paying Annuity provider would give.

The Annuity rates used were those applicable on 17th and 20th June 2011 and source using The Exchange.

The Annuity rates assume no enhancement due to health or lifestyle issues.

The actual Annuity income that an individual receives may be higher or lower than the figures shown in the table and is dependent upon the size of pension fund, personal circumstances, Annuity rates at the time of purchase, and of course the options you choose.