When most people retire, they will cash in their pension pot and use this money to buy an annuity. This is a guaranteed income for life paid by an insurance company in exchange for a lump-sum payment. The income you receive will be based on factors such as your age, sex, lifestyle and state of health – in short, how long you are expected to live.

Unfortunately, the vast majority of people simply buy an annuity from their existing pension provider, which can often mean that they do not get the best deal.

It is vital that you shop around for the best annuity. Since 2002 all pension savers have had this right – known as the open market option. If you do not, you could miss out on 30 per cent extra annual income.

There are various types of annuities to suit people with different lifestyles. Here is a brief guide.

The beginner's guide to self-invested personal pensions (Sipps)

BACKGROUND

• How to choose a pension

• Annuities explained

• How to make a will

• How to pay for long-term care

Enhanced and impaired annuities

Enhanced annuities are aimed at people with certain medical or lifestyle conditions – such as smokers and those with diabetes – and can provide up to 30 per cent more income than a standard annuity.

Nigel Callaghan, of Hargreaves Lansdown, the independent financial adviser, says: “It sounds brutal, but enhanced annuities pay more simply because you are not expected to live so long. There are 1,500 medical conditions that could entitle you to an enhanced annuity, so it’s worth telling insurers about any health problems you have and telling the truth about your smoking and drinking habits. Lifestyle factors such as these can make a big difference to your returns.”

If you have a very serious or terminal medical condition — cancer or heart problems, for example — you should be looking at an impaired annuity, which would provide you with a much higher return than a standard or even an enhanced annuity.

Single or joint?

If you are worried about your spouse or partner’s income after your death, you can opt for a joint annuity, which will continue paying out an income to your partner for the rest of his or her life if you die first. A single-life annuity will pay out more than a joint one, but it stops when you die.

Joint annuities can be calculated in various ways. For example, it can pay your partner the entire amount you received, or half (a 50 per cent joint annuity), or even less. The overall returns on the annuity will be made lower if you opt for your partner to receive a large percentage after your death, especially if your partner is much younger than you.

Level or escalating?

A level annuity pays out a flat rate every year for the rest of your life. With an escalating annuity, this amount will gradually increase by a small percentage each year to keep pace with inflation. You can fix the increases at a certain amount – say 3 per cent or 5 per cent – or you can opt for the annuity to be linked to the retail prices index.

Mr Callaghan says: “While a level annuity will pay out more initially, this money will depreciate over the years. What may seem a good payout this year will be worth much less in ten years' time. With escalating annuities, though it will pay out less at first, you have the peace of mind that it will increase in real terms in the future.”

Guarantees

A big concern with buying an annuity may be that you could die the day after handing over your pension pot. This would leave your estate with a hefty loss and your insurance company with a huge profit.

To protect against this happening, you can opt for a guarantee to be added on to the annuity for a set period of time, usually five or ten years. This means that your family will still receive some income if you die soon after purchasing the annuity.

For example, if you selected a ten-year guarantee on a 70 per cent joint annuity and died two years after taking it out, your partner would receive 100 per cent of the annuity’s returns for eight years and 70 per cent thereafter.

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Five websites

Moneyfacts Annuity best buys

FSA Money Made Clear

The Pensions Advisory Service

The Annuity Bureau

Annuity Direct