Ways to retire on a higher income
Poor-value annuity rates have focused attention on ways to boost the income you can derive from your pension pot at retirement, most notably by buying an ill-health, or 'impaired life', annuity that can lift income by as much as 30%.
However, if you dig a bit deeper there may be more you can do to improve your income in retirement.
Firstly, not all enhanced annuity providers offer the same rates for each condition, and shopping around is critical. For some risks, such as smoking, there is a relatively even market but for more specialised conditions and illnesses, rates vary a great deal.
Sometimes the extra income on offer for seven of the most common health complaints can be surprising. Having diabetes will give you an uplift of almost 23%, twice the additional income offered if you have a heart attack.
The key factors
Quite often a combination of factors will provide a higher rate even though the conditions may appear relatively trivial, such as a heart condition accompanied by recurring leg cramps. Do be aware however that the life insurance company may write to your doctor for verification.
Uplift is magnified when there are multiple conditions such as angina complicated by obesity or high cholesterol. Diabetes would also result in an even bigger uplift in conjunction with other symptoms.
Where a policy is written on a joint life basis, it is equally important to reveal as much as possible about the health of the second life, something that advisers say is often overlooked. Two conditions that are often not disclosed are arthritis and kidney disease, as their impact on life expectancy is not fully appreciated.
Some annuity providers take into account where you live, as certain postcodes have higher mortality rates than others, but this involves a surprising level of detail. In Glasgow, for example, life expectancy is just 71 for a man and 78 for a woman compared with 85 for men and 87 for women in the Kensington and Chelsea borough in London.
However, it is not enough to simply live in Glasgow – the insurance company will look at your street and individual property.
If you have several pension pots, you should aggregate them, especially if they are small. Two pots of £5,000 will typically generate around 20% less income than one pot of £10,000, as small pension pots pay lower rates and there is also a reduced choice of provider. Annuities are one area where diversification benefits are marginal.
Inflation-linked annuities are often undervalued because people generally prefer a pound in their pocket now, and typically underestimate their life expectancy. "People are put off when they realise they will only receive more from an inflation-linked product than from a flat-rate product once they have survived into their eighties,' says Mark Stopard, head of product development at Partnership.
However, Britons now spend 19 years in retirement on average. For a healthy couple aged 65, the likelihood is that one of them will still be alive and relatively fit in their 90s. The gender gap in life expectancy is also narrowing. In the 1980s there were four women over 90 for each man – that has now fallen to 2.7.
An inflation-linked product may also be a good fit for today's lifecycle patterns. The traditional assumption has been that expenditure in retirement is typically U-shaped.
To put it crudely, when people first retire they need a decent income because they go on holidays, eat out a lot and play endless rounds of golf, but their income requirements fall in their 70s as people become less active and take to staying in and watching TV, rising again in their 80s when they often need some form of care.
For various reasons, such as the prescription of statins (used to lower cholesterol), people are keeping fitter in their 70s and this has flattened the traditional expenditure U-curve, making it a good match for an inflation-linked product that rises steadily every year.
As baby-boomers are forced to work longer to save for retirement, and the state pension age rises, more people are considering delaying taking an annuity. However, they often focus too much on the future uplift and forget how much they will forgo in the next few years.
According to Key Retirement Solutions, a 65-year-old with the median pension fund of £25,000 could expect an annual income of £1,420 now, compared with £1,499 if they delayed to age 67. The person retiring at 67 would lose £2,840 in income – and have to live another 36 years to make the money back.
"When people consider delaying, they often don't think about how much income they will lose in those first years and focus purely on what they will receive in future," says Dean Mirfin, group director at Key Retirement Solutions. "But if they do the maths they would realise it will be a long time before they make up that lost income."
Even if our 65-year-old's health deteriorates while they are delaying an annuity purchase, and then develops diabetes and high blood pressure, at age 67 the £25,000 fund would then generate £1,715.94 per year, and the time it would take to break even with the conventional annuity would still be 10 years.
A person's eligibility for an enhanced rate typically doubles between the age brackets of 60-65 compared with 65-70; in other words, your understanding of your future health generally becomes a lot clearer after age 65.
Some people may delay annuitisation in the hope that annuity rates will rebound, but even if they rise 0.5% during the two-year delay, our guinea pig would still lose £2,840 and take 14 years to earn back the lost cash.
Annuity rates have edged up a little over the past few months because they are driven almost entirely by gilt rates, and central banks have pulled back on quantitative easing (QE). Unfortunately, this trend is unlikely to last as the Budget reaffirmed that the Bank of England's £375 billion QE programme will remain in place for the 2013/14 financial year.
Another way of potentially boosting your income is an arrangement linked to an investment fund, often referred to as a unit-linked annuity, which has the potential to continue growing your pension pot after you start taking income from it, but carries the risk your income might fall.
MGM Advantage offers unit-linked annuities tied to three funds selected by research firm Morningstar OBSR – the Investec Cautious, Newton Balanced and Jupiter Merlin Growth funds, which over the past three years have returned 24.4, 15.8 and 25% respectively. There are also links to three low-charging passive funds run by Vanguard with the tags "cautious', "balanced' and "adventurous', depending on their equity content.
"The market for unit-linked annuities has doubled over the past three years as people are worried about annuity rates, inflation, and being locked in,' says Andrew Tully, pensions technical director at MGM Advantage. "The test is if an investment fund can return more than 3% per year, it is likely to outperform a conventional annuity."
For a minimum investment of £50,000, Annuity Direct offers a managed drawdown scheme linked to Standard Life's GARS fund, a well-regarded absolute return fund that has risen 19.2% in three years.
Alan Higham, chairman of Annuity Direct, says it's much better to achieve steady growth in a fund's performance rather than volatility, as after a fund falls, it has to do twice as well to get back to square one. He usually asks a client exactly how much of their annuity money they need as regular income to survive. If a unit-linked annuity cannot provide one third more than this base level, then he usually advises against it.
For those who want returns to be smoothed over the years, there are with-profits annuities. Prudential's with-profits fund has grown 131% on a total return basis over the past decade, almost identical to the FTSE All-Share index, and for years it bucked the trend of disappointing with-profits returns. However, over the past two years its performance has started to fall back.
For those who want more security in a unit-linked product, MGM Advantage offers Investec's Multi-Asset Protector Fund, where it is guaranteed that the fund won't fall more than 20% in value. It aims to achieve growth from a diversified investment portfolio.
The original open annuity was from London & Colonial, based in Gibraltar, and at its launch in 2001 it offered unheard of flexibility. It can be linked to funds that, instead of emphasising preserving capital, maximise income. It can also be used to link to a diversified fund involving an array of asset classes if you believe that equities and bonds are stagnating. Either way, hefty fees apply, including an initial set-up charge of £175, a maintenance charge of £575 per year and £16 for each regular income payment.
This feature was written for our sister publication Money Observer
All investment returns are measured against a benchmark to represent “the market” and an investment that performs better than the benchmark is said to have outperformed the market. An active managed fund will seek to outperform a relevant index through superior selection of investments (unlike a tracker fund which can never outperform the market). Outperform is also an investment analyst’s recommendation, meaning that a specific share is expected to perform better than its peers in the market.
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.
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”.
Generally thought of as being interchangeable with life assurance, but isn’t. Life insurance insures you for a specific period of time, at a premium fixed by your age, health and the amount the life is insured for. If you die while the policy is in force, the insurance company pays the claim. However, if you survive to the end of the term or cease paying the premiums, the policy is finished and has no remaining value whatsoever as it only has any value if you have a claim. For this reason, life insurance is much cheaper than life assurance (also called whole of life).
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).
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
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.