Seven steps to take towards a better pension
Most people looking to retire this year will receive a fraction of the income previous generations enjoyed. Annuity payouts - the regular income you receive in exchange for your pension lump sum on retirement - fell by, on average 53% between 1994 and 2012.
Various factors are conspiring against those about to retire. Improvements in mortality - a measure of the number of deaths recorded - is raising life expectancy and putting pressure on annuity prices, as your pension money has to last longer.
Office for National Statistics data realeased at the end of 2012, indicates the mortality rate fell by 20,000 in 2011, the third consecutive year in which there have been fewer than 500,000 deaths in the UK. Currently, pension funds assume a 65-year old man will live to 87 but, if life expectancy continues to increase, that will shift to 90 by 2052.
Rising life expectancy has already slashed annuity rates. Twenty years ago, a £100,000 pension fund would have bought a 65-year-old man an income of more than £15,000 a year; by 2008 that had slipped to £7,900, and today the same sum generates just £5,300, on average. In addition, insurance companies face strict new Solvency II regulations from the EU, meaning they must hold back more in reserve against obligations.
For example, a man aged 65 can expect to live for another 23 years, but the regulations mean the provider will need to earmark sufficient funds for 25 years. To cap it all, annuity rates were also hit by the Bank of England's (BoE) quantitative easing (QE) programme, which involved buying UK government bonds (gilts).
This pushed down gilt yields - the amount gilts pay out as a proportion of their value - to levels not seen since the late 19th century. Gilt yield rates are central to the way annuities are priced by insurers.
In 2012, the BoE boosted QE by another £50 billion, taking the total purchases of gilts to £325 billion - 25% of the entire market. "If the government had announced that, in order to bail out the banks and help those who have borrowed too much, it had decided to raid people's pensions, there would be uproar," explains Dr Ros Altmann, a former adviser to the government on pensions policy.
"But, by calling it ‘quantitative easing', somehow it has got away with stealing older people's futures. QE is causing dreadful damage to pensions, pensioners and annuities."
So what can you do if you're approaching retirement?
Retirees can do a lot to help themselves by checking the market for the best annuity deal. Crucially, if you have a medical condition you think could impair your longterm health you should look at getting an enhanced or ill-health annuity, which may offer a lot more income.
Ill-health annuities are available if you are already suffering from a disease or condition such as diabetes or high blood pressure, but also if you have unhealthy habits such as smoking or heavy drinking, or are overweight. Some insurers also take your postcode into consideration, so if your address is not in the most salubrious of areas, this might be worth investigating.
In fact, it is now crucial to look at the ill-health options; as the numbers who choose to do so grow, the remainder of the market will be increasingly healthy and standard annuity rates will worsen. "People need to remember to flag up medical and lifestyle conditions as this can give them significantly more income every year," says Andrew Tully, pensions technical director at MGM Advantage.
"There is roughly a 50% difference between the worst standard rate and the best enhanced rate for someone with ‘moderate' health conditions, so it can make a huge difference."
A number of other options also offer increased flexibility for those about to retire in this difficult environment. For example, it is possible to buy a temporary or fixed-term annuity before you make the irrevocable decision to buy a lifetime annuity, which will consume your pension pot once and for all.
A fixed-term annuity will provide a specified income for a set period of time - anything from three to 25 years - so you can review your situation when the term ends. You might choose this if you are in good health and cannot take advantage of an impaired annuity, or if you need a joint annuity but your spouse is not well and may die during the annuity term.
At the end of the fixed period, you receive a guaranteed maturity payment that you can invest in another annuity - and by then you might be able to get a better rate as a result of a health problem, or switch to a single annuity. However, if you remain in fine health, this might simply delay fully converting your whole pension pot to a time when guaranteed annuity rates have fallen even further.
This alternative involves leaving your pension fund invested and drawing an income directly from it.
Inflation can have a vicious effect on retirement income. You can buy index-linked annuities that rise in line with inflation but the guarantee is expensive and the amount you receive at the outset could be very low.
Another solution is asset-backed or investment-linked annuities. These are unaffected by gilt yields, and offer the potential for investment growth to protect against rising inflation and falling annuity rates.
They incur more risk but can generate higher rewards. For this reason, they tend to be used by people with larger pension pots - typically over £100,000 - and those who can afford to take a bet on the stockmarket.
However, firms do offer them to clients with as little as £10,000 to invest.
If you're looking to retain control over your money in retirement, one solution is the oddly named ‘scheme pension'. This is particularly attractive for people in ill-health as the level of income drawdown is ‘personalised', based on your own life expectancy.
It may therefore allow higher levels of income in certain circumstances and while this is normally for those with impaired health, it can work out better even for healthy individuals.
Furthermore, if you develop a serious health condition at any time, the scheme's actuary can review the income levels immediately and increase them accordingly.
Another option is flexible drawdown, but this is only available to people aged 55 and over who are already drawing at least £20,000 a year in secure income from state pensions, pension annuities and pension schemes combined.
Those fortunate enough to meet this threshold can cash in the remainder of their pension fund as and when they like. However, amounts above the normal tax-free lump sum will be taxed as earned income.
If you're worried about retirement income, you could continue to work. Assuming you earn enough, you could carry on contributing to your pension. The older you are when you come to take an annuity, the better the rate you'll get.
A non-smoking, 65-year-old man with a £100,000 pension might receive a conventional level annuity of up to £6,400 if he retired now; a 70- year-old in the same situation would receive £7,300.
By delaying your state pension you can boost your eventual payout by around 10% for every year of deferral. If you put it off for five years (assuming no increase in state pension rates) you would receive almost £8,500 instead of the current rate of £5,728. But, of course, there is a price to pay in terms of continuing work commitments and the sacrifice of what is likely to be the healthiest period of your older years.
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
The term is interchangeable with stock exchange, and is a market that deals in securities where market forces determine the price of securities traded. Stockmarket can refer to a specific exchange in a specific country (such as the London Stock Exchange) or the combined global stockmarkets as a single entity. The first stockmarket was established in Amsterdam in 1602 and the first British stock exchange was founded in 1698.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
Tax-free lump sum
An inelegant phrase that is nonetheless accurate in what it describes: a one-off payment to a beneficiary that is free of any form of taxation. Usually received when using a pension fund to purchase an annuity, as 25% of the overall fund can be taken as a tax-free lump sum.
An alternative to an annuity, income drawdown (also known as an unsecured pension) allows you to take income from your pension fund while the fund remains invested and so continues to benefit from any fund growth. The drawdown of income has to be calculated carefully as taking too much income could exhaust the pension fund so experts say the annual drawdown must not exceed what the assets would normally yield in an average year. The invested pension fund could also be hit by market turbulence and the value of the assets could fall.
A type of derivative often lumped together with options, but slightly different. The original derivative was a future used by farmers to set the price of their produce in advance before they sowed the seeds so that after the harvest, crops would be sold at the pre-agreed price no matter what the movements of the market. So a future is a contract to buy or sell a fixed quantity of a particular commodity, currency or security (share, bond) for delivery at a fixed date in the future for a fixed price. At the end of a futures contract, the holder is obliged to pay or receive the difference between the price set in the contract and the market price on the expiry date, which can generate massive profits or vast losses.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.