How you can retire in comfort
Back in January this year we set out the case against the insurance companies that are failing to encourage their pension customers to shop around in the open market when they come to take an annuity or retirement income from their pension funds.
As a result, up to two-thirds of retirees end up with the annuity offered by their pension company - even though it's typically not the best rate and often not the most appropriate product for their circumstances.
This month, we'll look in more detail at how the system could be improved, and what other options are available to you when drawing from your pension.
As things stand, the default position is that although pension companies must tell their customers about the open-market option and their right to compare annuity rates from other providers, it's not exactly trumpeted.
So some of us don't realise that we might get a better income elsewhere, while others simply can't be bothered to make the extra effort involved.
Either way, too many of us accept the annuity quote from our pension company. It's easy money for the providers.
Moneywise backs the proposal from the Pension Income Choice Association (PICA), which is currently under discussion in the industry. This basically does away with the idea of an optional open market and instead makes 'shopping around' the default position for retirees, via a three-step process.
PICA's Three Step Process
1. As retirement approaches, instead of the current 'wake-up pack' from the provider, you're sent a short, simple, generic brochure outlining all the options for retirement income and what you need to do.
2. Nearer the date, instead of an annuity quote, your pension provider sends you a pre-filled 'Pension Passport' - a standard one-page document with the basic details about you and your pension fund. You'll use that form to get quotes from other providers, ensuring you end up with the right kind of product and the best rate - whether through an annuity supermarket, by phoning individual annuity providers, or via an IFA.
3. When you've made your mind up, you simply let your pension provider know which company and product you would like to go with.
To test the idea, PICA did some market research, which was independently analysed. The findings, says PICA's board director Steve Lowe, were "unanimously positive".
Not only would pensioners be better off financially (by sums ranging from a few pounds a year to many thousands), but those questioned were very enthusiastic about the three-step process as an alternative to the existing system.
Of course, insurance companies are not so enthusiastic and put a different slant on the situation. At Prudential, head of business development Vince Smith-Hughes, says: "PICA needs to be careful that it doesn't throw the baby out with the bathwater. People are aware of the open market option, but a lot choose to stay with their provider.
"For instance, many people with small funds know they could get a better rate elsewhere but don't want the delay of a month or six weeks that's involved in moving to another annuity provider."
However, Moneywise and PICA both believe that people should consider the whole spectrum of retirement income options, not just lifetime annuities, when they come to make a choice.
"At the moment, conventional annuities account for nine out of 10 of all sales in the market - but is that a matter of choice, or is it apathy and the tactics of the insurance companies?" asks Lowe.
What are the choices available?
For retirees who want a secure income without any investment risk, annuities remain the obvious choice, especially for those with smaller pension pots - £10,000 is the usual industry minimum.
Pension companies will automatically offer you a conventional annuity, but even quite minor medical problems may qualify you for a so-called enhanced annuity paying a higher income (Association of British Insurers figures suggest that only 50% of those eligible for an enhanced annuity actually buy one).
But there are downsides to annuities. Current buyers are faced with falling annuity rates - yet once you've bought these products there's no going back if rates pick up or your circumstances change. Moreover, your remaining pension fund effectively 'dies' when you do, ending up in the insurance company's coffers.
Fixed-term annuities sidestep some of those problems and are growing in popularity as a "good compromise", according to IFA Peter Leonard at the Munro Partnership. They deliver the same secure income as lifetime annuities but run for a chosen term - the minimum is three years.
On maturity, a pre-determined sum of the pension pot is returned and you can buy another fixed-term annuity or any other available retirement income product.
There are several advantages to fixed-term annuities. First, they work for all sizes of pension pot, in the same way as a conventional annuity - for example, market-leading provider Living Time has dealt with pension pots as small as £4,000.
Secondly, says Chris Glazier, managing director of IFA Tom French & Associates, "you can delay the commitment to a lifetime annuity until later in your life - one in two of those who are healthy at 65 are no longer in good health by the time they reach 75".
Brian Farquhar, aged 65, who recently retired from his job as a sheet metal worker in Edinburgh, was steered towards a Living Time 10-year annuity by his IFA Duncan Philp of Macbeth Currie. "I had a pension pot of £50,000, so it was important to make the most of it, and this gave me the best rate available to me," he explains.
Moreover, although Brian still enjoys good health, by the time his annuity matures he may qualify for an enhanced rate if he has developed any medical problems.
REWARDS AND RISKS
Fixed-term annuities have another advantage: because there's no lifetime income purchase involved, they count as 'unsecured pensions' (like income drawdown-based plans). That means the remaining pension pot can be returned to your spouse or estate if you die during the term.
There is some risk attached. Annuity rates could continue to fall, so you could eventually renew your annuity contract on an even worse rate - although falling rates are likely to be offset by your greater age and potentially deteriorating health. But, conversely, rates could rise, further boosting the income from your next annuity.
The other options all involve some stockmarket exposure - but also the potential for a rising income over time. They include with-profits annuities, where your lifetime annuity is backed by a with-profits fund, which means any capital growth is 'smoothed' to provide a steady increase in income over the years.
But with-profits funds are expensive and complex. A more transparent (but riskier) alternative is a unit-linked annuity, where an ordinary unit trust is used for the investment.
INCOME DRAWDOWN BENEFITS
If you have at least £100,000 and can stomach the stockmarket rollercoaster, then income drawdown is a highly flexible alternative, again with the big advantage that the pension fund can be returned to the family if you die. But you risk seeing your pension pot possibly halve in value if markets crash.
VARIABLE ANNUITIES' GUARANTEE
Certainly, once they stop working altogether, most people look for greater income security than conventional income drawdown can provide. This is where so-called variable annuities from providers such as MetLife come in. They still aim for investment growth, but it's lower because some of it is used to provide an income guarantee.
Alan Loomes of IFA Fraser Heath stresses: "The choice is very much driven by the client's individual needs. For instance, you'll pay annual charges of between 3% and 3.5% for a variable annuity. However, I have found that many of my clients are prepared to pay that cost because they want the income guarantee, plus some growth potential, as well as the death benefits."
This range of options beyond the lifetime annuity arena is likely to expand further as the annuity landscape changes.
But the difficulty is that while it's straightforward to compare conventional annuity rates through comparison sites or by ringing a broker, if you want to explore the alternatives you really do need the help of a specialist IFA who can assess what's best for you, given your circumstances, health, resources, attitude to risk and so on.
However, the additional cost of such professional advice is something that many people with smaller pensions and fewer realistic choices will baulk at. So where will such support come from, in the brave new world of shopping around?
"It would be lovely if everyone was on safe, straightforward final salary pensions, but that's not possible, so in the end it has to be the responsibility of the individual to work out what they need and find the best option," says Tom McPhail, chairman of PICA and head of pensions research at broker Hargreaves Lansdown.
"But we need to make it as easy as possible for people to make these decisions."
Do you feel you are receiving a raw deal when drawing your pension? Voice your opinion and join our campaign for fairer annuities
A collective investment vehicle (known in the US as a “mutual” or “pooled” fund) and similar to an Oeic and investment trust in that it manages financial securities on behalf of small investors who, by investing, pool their resources giving combined benefits of diversification and economies of scale. Investors buy “units” in the fund that have a proportional exposure to all the assets in the fund, and are bought and sold from the fund manager. The price of units is determined by the value of the assets in the fund and will rise or fall in line with the value of those assets. Like Oeics (but unlike investment trusts) unit trusts and are “open ended” funds, meaning that the size of each fund can vary according to supply and demand of the units form investors. Unit trusts have two prices; the higher “offer” price you pay to invest and the “bid” price, which is the lower price you receive when you sell. The difference between the two prices is commonly known as the bid/offer spread.
With-profits funds are administered by life assurance companies and access to them is through the life company’s products such as bonds, endowments and pensions. Your monthly contributions are pooled with other investors’ money and invested in a mixture of shares, bonds, property and cash. Each year, a “reversionary” bonus (a declared percentage) is added to your investment and a large part of the policy’s final value depends on these bonuses during the investment period. In years when the with-profits fund performs well, some of the return is held back and paid out in years when the fund does badly and this “smoothing” process makes with-profits investments unique. When the policy matures, the life company may pay a discretionary “terminal bonus”.
Open market option
People who have a money purchase or defined contribution pension, at retirement must use their fund (minus an optional 25% as tax-free cash) to purchase an annuity. As the annuity market is very competitive and rates differ vastly between annuity providers on a daily basis, the open market option is your right to shop around and buy the annuity from the company offering the highest rates at that time.
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.
Association of British Insurers
Established in 1985, the ABI is the trade body for UK insurance companies. It has more than 400 member companies that provide around 90% of domestic insurance services sold in the UK. The ABI speaks out on issues of common interest and acts as an advocate for high standards of customer service in the insurance industry. The ABI is funded by the subscriptions of member companies.
Everything you own: all your assets (property, cars, investments, savings, insurance payouts, artwork, furniture etc) minus any liabilities (debts, current bills, payments still owed on assets like cars and houses, credit card balances and other outstanding loans). When you’re alive this is called your wealth; when you’re dead, it becomes your estate.
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.
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.