Annuities: What are your choices now?
When I last wrote about annuity rates for the BBC in January 2010 I said that I did not expect annuity rates to increase this year and unfortunately I was right.
At the beginning of the year our benchmark annuity (£100,000 invested in a joint life annuity, for a man aged 65 and woman aged 60 with 2/3rds spouse's pension) was paying £5,897 per annum.
By March this had increased to just over £6,000 per annum, but at the beginning of September it had fallen to £5,673.
This represents a fall of 4% since the beginning of the year, putting annuity rates at the lowest level since I started collecting data 20 years ago.
The reason why annuity rates fell so significantly in August was the reduction in the yields on gilts and corporate bonds as a result of continued uncertainty in global financial markets, especially the US.
The point here is that annuities are largely invested in bonds and the return on them determines the income that an annuity can provide.
The big bet
At retirement most people with personal pensions, and some types of company pensions, convert the capital into a pension income by buying an annuity.
In return for the capital sum, an insurance company guarantees to pay an income for the rest of your life no matter how long that is.
Put simply, if you live past your normal life expectancy you win the bet with the insurance company as you will have taken out more than your share.
But if you die earlier than expected you will have taken out less than your share.
The amount of income paid by an annuity is calculated with reference to the current yields on gilts and corporate bonds as well as your life expectancy.
The problem is that yields have fallen and we are living longer, and these are the reasons why rates have fallen.
Maximise your income
So what can you do if you are approaching retirement and want to get the most income from your pension pot despite falling annuity rates?
If you only have a modest pension fund, say below £50,000, your options are limited.
You will probably not be in a position to take any risk, but there are still a few things you can do to maximise your income.
First you should ensure that your pension fund is invested safely as you get nearer to retirement.
Your pension income is a product of the size of your pension fund as well as annuity rates.
If you are 100% invested in equities and there is a stock market crash just before you retire you will have a smaller fund with which to buy an annuity.
Therefore it makes sense to switch into safer investments in the run up to retirement.
Poor or ill?
Secondly, you should ensure that you shop around for the best annuity because the rates paid by different companies can vary by as much as 30%.
It costs nothing to do this and it is called taking the open market option.
If you live in a less affluent part of the country you will get more because annuities are priced according to your postcode.
Thirdly, you should ensure that you apply for an enhanced annuity if you have a medical condition that may reduce your life expectancy.
One of the most frequent questions asked is whether it makes sense to defer an annuity purchase in the hope that rates will rise.
This is a complicated area, but as a rule of thumb it rarely makes sense to defer an annuity purchase.
You will miss out on income payments and if rates fall even further you will be worse off.
Take a risk?
If you a have a larger pension fund, say over £50,000, and are prepared to take some risk you have more options to overcome the slump in annuity rates.
You could consider a fixed term annuity which pays a guaranteed income for a set number of years.
At the end of the period you are guaranteed to be paid a lump sum which must be used to purchase another pension income policy.
The advantage is that if rates increase or your health deteriorates you may get a higher annuity in the future.
The risk is that if rates fall even further you will get a lower income.
Another option is to consider an investment-linked or flexible annuity where your annuity fund is invested in equity-based funds.
The logic of an investment-linked annuity is that an annuity is a long-term investment and therefore should be backed by investments that have the potential to provide some income growth.
The most popular type is a with-profits annuity, but there are some newer policies that provide more flexibility and a choice of investment funds.
Continue to invest
Most investment-backed annuities have an element of guaranteed income.
As the income from an investment-linked annuity can fall as well as rise, it is only suitable for those who have other sources of income or capital to fall back on if the income does fall.
The alternative to an annuity is called pension drawdown, or to use its proper name, unsecured income.
Instead of committing to a lifetime income, your pension fund remains invested and income payments are made directly from the pension fund.
There are limits on the maximum amount of income you take in one year and that is approximately 120% of the income from a single life annuity.
The advantages of pension drawdown are as follows:
- Income flexibility - you can take up the maximum allowed each year.
- Investment control - you can invest in a range of investments.
- Choice of death benefits - including a lump sum less 35% tax (this is due to change to 55% next year).
Until recently there was effective compulsion to buy an annuity at age 75 but this is in the process of being scrapped.
It is proposed that from next year the very unpopular Alternatively Secured Pension which allowed a restrictive drawdown after age 75 will be replaced by two new types of drawdown.
The new rules have yet to be finally agreed but it seems likely that even those with modest pension funds will be able to continue in drawdown for life without ever buying an annuity.
Drawdown is more risky than buying an annuity.
A particular concern is that if the pension fund is invested unwisely or there is another stock market crash investors may end up with less income than if they had bought an annuity.
Although the standard fixed annuity will remain the first choice for most pensioners, especially those with modest pension pots, there is now more choice and it is important to consider all the options.
The opinions expressed are those of the author and are not held by the BBC unless specifically stated. The material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Links to external sites are for information only and do not constitute endorsement. Always obtain independent, professional advice for your own particular situation.