What are the alternatives to annuities?
Annuities are essentially an insurance policy - in exchange for your pension fund they will pay you a guaranteed income for the rest of your life.
This means they can offer fantastic value for money if you go on to live a very long life, with the potential for you to receive more back in income than you paid for your annuity. For example a person receiving £5,000 a year on a £100,000 pension fund who lived for more than 20 years after buying their annuity would get back more than they invested.
However because annuity providers need cash to pay for all those policyholders that live longer than expected, those who don't live quite so long stand to lose the remainder of their savings. This can be a bitter pill to swallow, particularly for those that die very early on in their retirement.
You can reduce this risk to a degree by taking a joint life policy to protect your spouse after your death, or you can buy a guarantee that payments will be made for five or 10 years even if you die within that period. Nonetheless all this protection comes at a price and reduces the overall level of income you can receive and you may still lose a large chunk of your fund.
Conventional annuities are also notoriously inflexible, once they've started there is no going back so you don't have the opportunity to switch to another provider or change your payments if your circumstances change.
The good news is you don't have to use your pension fund to buy an annuity as rules that previously forced retirees to secure their income with an annuity in their 70s have now been scrapped. Income drawdown, as well as fixed-term, flexible or investment-linked annuities, all provide consumers with an increasing array of choices.
Income drawdown enables you to leave your pension fund invested and draw an income from it. The benefit of this is that you retain ownership and control of your money and the income you take from it. The amount of income you can draw is capped at 120% of the income you would have been able to get with a single life conventional annuity. Wealthier investors, who can prove they have a guaranteed income of £20,000 a year from other pensions including state and company pensions, may be eligible for flexible drawdown, where no caps apply.
Alternatively you can opt for fixed term annuities which provide an income over a pre-agreed period such as five or 10 years, plus a sum on maturity which would then be used to buy another retirement income product to secure your income going forward.
Investment-linked annuities meanwhile are like a halfway house between an annuity and income drawdown. As the policy is invested, there is the potential for your money to continue to grow and you can vary the income you take, however like a conventional annuity you can normally guarantee a minimum level of income. Andrew Tully, pensions technical director at MGM Advantage says: "It can be a good way of getting some flexibility, but is lower risk than income drawdown."
So what's the best way to turn your pension into a retirement income stream?
The right solution for you will be guided by three factors - your health, your attitude to risk and the amount of money you have to generate your income.
"If you are poorly, have a health impairment or even just, smoke, drink or are overweight you may be able to get an enhanced annuity," explains Steve Lewis, head of retirement distribution at LV=. These pay a higher rate of income than a conventional annuity because you are likely to have a lower life expectancy as a result.
But, people who are more seriously ill may be better off steering clear of annuities altogether. This is because you run the risk of losing much of your capital. "If you are very poorly death benefits really become an issue," warns Lewis. "It may be more attractive to use drawdown rules which would allow the remaining lump sum to be paid to the spouse."
Your attitude to risk
Your attitude to investment risk will be very important in determining whether you plump for a guaranteed annuity income or a flexible one linked to income drawdown or an investment-linked annuity but it's not the only risk to consider.
"People hugely underestimate inflation risk," points out Tully. An income that covers your costs at 65, will not have nearly the same level of buying power 30 years down the line, making this a real concern for all retirees but particularly those in a very good state of health.
Lewis says this explains why equity release has because such a big market. "Let's take someone with £1,200 monthly income on a level annuity with outgoings of £1,000 a month. With inflation at 3% it would only take six years for that monthly surplus to run out."
Both investment-linked annuities and income drawdown can be useful in hedging inflation risk because you give your pension fund the opportunity to carry on growing. The downside of course is that if stock markets fall, so will your capital.
Then there is 'change' risk to consider. What if you get divorced or decide to go back into work or move overseas? All of these factors may mean that you need to change your income requirements, which won't be possible with a conventional annuity.
Finally you must consider annuity rate risks. While a fixed term annuity or income drawdown might suit you in the early years of your retirement you may want the security of an annuity later on. However without a crystal ball it's impossible to predict annuity rates and if rates are lower than they were when you originally retired you could end up worse off overall. As Lewis says: "If you don't buy an annuity today we can't guarantee the rate you will end up getting."
On top of your attitude to risk and your state of health, you choices will invariably be influenced by the amount of money you have. Flexible drawdown, for example, which really gives you maximum control of your retirement income, will only be open to retirees who can prove an income of £20,000 a year from other pension sources. "This really just becomes a lifestyle fund that you can access whenever you need the money," says Lewis.
Income drawdown as a whole is only really suited to wealthier retirees, this is because your income is not guaranteed and your capital could run out. "Some say you need at least £100,000 to be going into drawdown but it can be less depending on your circumstances," says Lewis, for example if you have alternative sources of income as well.
By considering all these factors yourself you may start to get an idea of the sort of retirement income products would best suit you, however with so many options available to you- and the ability to mix and match strategies - it is worth taking advice. "Advice is massively important in helping you weigh up the different risks," says Tully. "And if you have £50,000 or more I would certainly take advice."
Tully estimates that you can expect to pay in the region of £750 for decent independent advice. While this might sound like a lot to pay upfront, it could prove to be a valuable investment - whether they secure you a higher income or the flexibility to change your arrangements if your circumstances change. Proving the value of advice he adds: "In 2012 approximately 40% of all advised sales went to enhanced annuities, but in the non-advised market just 5% did.
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.
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).
A term to describe financial products or ‘plans’ that help older homeowners turn some of the value (equity) of their homes into cash – a lump sum, regular extra income, or sometimes both – and still live in the home. There are two main types of equity release: lifetime mortgages and home reversion plans (see separate entries for both). Whichever type you choose, you borrow money against the value of your property, on which interest is charged, and the loan is repaid when the house is sold after your death.
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.