Annuity types

Now for the annuity itself. The basic type comes in two versions: level and escalating:

1. Level

The income provided remains the same year after year, for life. Two out of three pensioners buy this type of annuity, largely because the starting income is higher than with an escalating annuity. However, because the income is fixed it is vulnerable to inflation. For example, if inflation averages 3 per cent a year, the buying power of £2,000 falls to £1,488 after ten years and to £1,108 after 20 years. Could you cope with this situation? One solution is to take a level of annuity, but save some of it in the early years to deal with inflation later on.

2. Escalating

The income provided goes up each year by a fixed rate, for example 3 per cent. Protecting your income against inflation in this way is expensive: your starting income will be 30-40 per cent less than if you had chosen a level annuity. It could take ten or more years for the increasing income to reach the same annual amount as a level income, and around 20 years before the total paid out by the escalating annuity exceeds the total of the level annuity. Some escalating annuities are linked to inflation. Instead of increasing by a fixed amount, they reflect changes in the Retail Price Index - which can fall as well as rise.

You must also decide whether you want a single life annuity - an income for you alone - or joint life, which provides for your spouse/partner after your death. And what about a guaranteed period - perhaps 5-10 years - during which time, even if you die, the income will continue to be paid.

Inevitably, options like "joint life" and "guarantee period" reduce the amount of your initial income. Payment arrangements also have a slight impact. Income is paid in regular instalments, such as monthly or quarterly, and can be taken in advance or in arrears; in advance usually pays less, in arrears more.

You might also be able to boost your income via an impaired-life or enhanced annuity. These are for people whose life expectancy is shorter than average because of illness - like heart disease, cancer, stroke, kidney failure - or because of the factors such as smoking or obesity. With an enhanced annuity, a heavy smoker could receive up to 10 per cent more income.

For people with significant pension pots - over £100,000 - and who have additional sources of income and are not risk-averse, other options include investment-linked annuities; income drawdown, which takes an income directly from the pension fund until the annuity is purchased; and phased retirement, which buys a series of annuities at different times. As these options are more complicated, and involve costs and risks, you will need specialist advice.

Time to choose

But when it comes to a basic annuity, your pension fund company makes it very easy for you to choose a "level, single-life, no-guarantee, monthly in arrears" annuity. They will probably contact you with background information about two months before your 60th birthday. Then, much nearer to the date, when the value of your pension fund has been finalised, you will be invited to complete an annuity selection form: just tick the boxes.

But stop! Are they offering you the best possible annuity rate? An annuity rate governs the amount of income paid by a pension pot and is usually expressed as a percentage. For example, an annuity rate of 6 per cent is the same as £600 a year income for every £10,000 in your pension fund.

To get the highest rates available, you may do better to shop around and buy your annuity from another provider. This is called using your "open market option" and, with differences of over 10 per cent between best and worst rates, it can be very beneficial. On a pension pot of £50,000, for instance, a 1 per cent difference will yield an extra £500 per year - £10,000 over 20 years.

Although you can go the OMO route yourself - tables of annuity rates are available on the Internet - there are pitfalls: you must, for instance, compare like with like, understand what your own provider is offering and check up on any penalty charges for switching.

It can also be a time-consuming, confusing and frustrating process, especially if you have to contact overseas call centres. Furthermore, not all annuity providers deal direct with consumers so it makes sense to get a specialist IFA to find the best rates for you. Usually the IFA is paid commission by the annuity provider and the amount you receive will not be affected.

With both the start pension and, especially, an annuity it pays to start thinking about them well in advance. The decisions you make are funding your future.