How to make your pension pot work for you
When you have worked hard all your life to build up a pension pot, surely you'd take some time out when retirement beckons to ensure it doesn't all go to waste?
Or would you? According to research from annuity provider Just Retirement, less than a third of retirees shop around for the best deal - making the most of the open-market option - and instead use their hard-earned cash to buy their annuity straight from their pension provider.
But there's often a vast gulf between the best and worst annuity deals. Indeed, the Annuity Bureau puts the cost of not shopping around at about £52.9 million a year; those who shop around increase their retirement income by between 10% and 40%, depending on their circumstances.
How you put your pension money to work is arguably the biggest financial decision of your life, and the wrong choice made in haste could cost you dearly. With the typical UK pension in the region of £25,000 and the average retirement period nearly 17 years, it doesn't take a genius to work out that every little bit counts.
Annuities are the first port of call for most retirees - in fact, most of us are legally obliged to purchase annuities when we turn 75. (The much heralded 'alternatively secured' pension, which would have allowed you to carry on drawing down money from your pension fund beyond this age, was effectively killed off by the Government's decision to apply a 70% tax charge to the fund on death.)
However, following last year's new pension legislation, you now have a lot more choice as to how you use your pension fund before you reach 75 in order to generate your retirement income. This is great news for retirees, but it also means it's even more important that you take the time to make the right choice.
So, if you're approaching retirement, what are your options?
Annuity rates have fallen to less than half their 1990 value because life expectancy has increased and gilt yields - on which annuity rates are based - have plummeted. Although rates have risen again of late, this is likely to be temporary as life expectancy is still increasing.
Despite this, an annuity remains the most sensible way for most retirees to arrange their retirement income. This is because they are the only product that can guarantee you an income for life. However, unlike your mortgage or savings account, you cannot switch if you make the wrong choice - so it pays to make sure you get the right annuity for you.
Level annuities pay a flat rate of income for the rest of your life, and they initially pay the highest rate of income. However, there are other factors you need to take into account. Inflation, for example, can seriously erode your income over time. Theoretically, an inflation-linked or escalating annuity, which pays a rising income, would be a good choice.
You also need to think about your personal circumstances. If you're married, for instance, a joint life annuity would mean the payments continue for the surviving spouse after the first one has died, whereas a single life annuity ends on the first death.
Similarly, if you smoke, your health is poor, you've had major surgery or you're obese, impaired life or enhanced annuities could be more suitable. These pay a higher income as you aren't expected to live as long as a healthier person.
If you don't like the fact that annuities tie you in for life, you can get around this. Some firms offer flexible annuities, including Canada Life, whose annuity growth account is based on five-year temporary annuities. The downside to these is that they are partly stockmarket-linked, so there's a risk that the income could fall as well as rise. As a result, if an annuity is your only source of income in retirement, a stockmarket-linked plan isn't for you.
There is, however, one company that offers a more flexible annuity without stockmarket risk. Living Time's fixed-term annuity plans offer a fixed income, like normal annuities, but unlike the traditional product, they can end at any time before the age of 75, with a minimum term of five years.
It also provides a guaranteed amount at the end of the term, which you can use to buy either a lifetime annuity or a drawdown plan. Unlike traditional annuities it has good death benefits, meaning that your partner or a beneficiary can get a lump sum or income after you die.
If you're blessed with a decent pension pot - say £100,000 or more - and you're not relying on it for a fixed-income stream, you may want to get more out of it than is offered by traditional annuities. This will involve taking more risk, but if you're happy with that, income drawdown (also known as an unsecured pension) is an option worth considering.
Income drawdown allows you to draw an income direct from your pension without cashing it in. It has two key advantages: you draw an income directly from your pension - after taking 25% of it tax-free - while leaving it invested, meaning you can delay taking an annuity until you turn 75. Under the pension rules introduced last year, you can draw down income of up to 120% of the equivalent you'd get from an annuity, and you can review the income level every five years.
This flexibility is attractive, as are the death benefits, but there are strings attached - because you're leaving your pension invested, there's a danger that it (and therefore the income you get from it) could fall. If you have another source of income, such as property, income drawdown might make more sense than an annuity as you can control how much income it gives you while potentially letting your pension fund grow. But if you haven't got another income and you don't want to risk your pension fund, income drawdown isn't for you.
The third way
If you want more income than your pension fund would get out of an annuity, but income drawdown seems too risky - as it is for most retirees - all is not lost. Over the last year or so, a new breed of retirement plan has emerged, combining the certainty of annuities with the growth potential of drawdown.
US insurance giant Hartford Life is among the firms to have spotted a gap in the market, last year launching the Hartford Platinum plan. This guarantees that the value of the fund can grow but you can 'lock in' to a minimum income, preventing the level of your income from falling if the underlying investment falls.
Lincoln Financial also has a drawdown plan with a guaranteed minimum income, while MetLife's drawdown offering promises a guaranteed fund value from shortly before the 75th birthday, with the value of the fund locked in every five years. There's also the option to withdraw up to 5% of the initial investment until shortly before age 75, regardless of market conditions.
Elsewhere, Aegon Scottish Equitable last year introduced the '5-for-life' plan. This is essentially an investment bond which promises 5% income for life and the chance of investment growth through a mix of fixed interest and equity funds. The minimum investment is £15,000.
The '5-for-life' plan gives you a degree of control, as growth can be locked in at certain points, although any additional withdrawals will reduce the guaranteed income level. Unlike Hartford Platinum, where investment growth is capped at 10%, '5-for-life' passes on all the growth.
So, whatever you decide to do, make sure you consider all your options. Whether you just shop around for an annuity at the best rate or opt for something a bit more adventurous, it's worth taking the time to ensure all the effort you put into saving for your pension pot isn't undone when you retire.
Issued by life companies and designed to produce medium- to long-term capital growth, but can also be used to pay income. The minimum investment is typically £5,000 or £10,000 and your money is invested in the life company’s investment funds, so the bond can either be unit-linked or with-profits. They offer a number of tax advantages, such as the ability to withdraw up to 5% of the original investment amount each year without any immediate income tax liability. Also, a number of charges and fees apply, such as allocation rates, initial charges, annual charges and cash-in charges. As investment bonds are technically single-premium life insurance policies, they also include a small amount of life assurance and, on death, will pay out slightly more than the value of the fund.
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).
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.