Best buys for your pension pot

Choosing the right annuity has always been tricky and fraught with danger — and that was before the current financial crisis and recession.

With pension funds hammered and annuity rates sliding, many will be wondering whether they should buy an annuity now, or wait until the situation improves.

About 680,000 people are hitting retirement age this year, and more may be thinking about buying an annuity earlier because they have been made redundant.

An annuity is the regular income that you buy with your pension pot. It lasts for the rest of your life, so it is vital you make the right decision. The bad news is annuity rates have fallen from a peak of 7.9 per cent last summer to 7 per cent today.

That means a single man aged 65 with a pension pot worth, say, £100,000, can get a maximum income of around £7,000 a year, or just £4,500 if he wants it inflation-proofed, according to figures from the Alexander Forbes Annuity Bureau. A couple aged 65 could get a level joint income worth £6,500 a year, falling to just £4,000 index-linked.

These are the best rates , so unless you shop around you could end up with much less. Worse, most people do not have even £100,000 in their pension pot. The average pension fund is worth about £25,000.

Will annuity rates rise?

Annuity rates may look disappointing right now but they always do, says Laith Khalaf, pensions analyst at Hargreaves Lansdown.

“Rates are never as good as you hope. One reason is we underestimate how long we might live these days. People don’t like annuities but studies show that they are good value.”

Rates soared as high as 15 per cent in the early Nineties but life expectancy has increased since then, and crucially, inflation has gone down. So in real terms, you aren’t much worse off.

Nobody can predict whether annuity rates will rise or fall in the next few years.

The Bank of England’s decision to print money to revive the economy could force them even lower but if it ends up sparking inflation, they could rise.

“You shouldn’t try to second guess annuity rates because you can make the wrong bet as often as the right one,” Khalaf says.

Could my pension fund recover?

With the FTSE 100 up almost 30 per cent since March, some will be wondering whether to delay buying an annuity in the hope their pension fund will recover its lost value.

If you think markets will rise further, you should consider something called income drawdown, or an unsecured pension.

Instead of taking your annuity, you can draw the maximum 25 per cent tax-free lump sum from your pension fund and keep the rest invested in equities, drawing any money as you need it.

Income drawdown typically works best for people with larger pension pots, of at least £100,000 and preferably more, because charges can be high, and a market crash could wipe out a smaller fund.

You can put off taking your annuity until aged 75, when it finally becomes compulsory.

Alternatively, you could hedge your bets by using a chunk of your pension to buy an annuity now, and more in future.

Your decision will also depend on whether you have enough income to live off before you buy an annuity.

You should also check the small print of your pension scheme, says Stuart Bayliss, director at Annuity Direct. Until the mid-1990s, some schemes guaranteed members a minimum annuity rate, often as high as 11 per cent or 13 per cent.

“This looks extremely attractive now but you may have to draw your annuity on a set date to qualify. If you delay, you could lose that valuable guarantee.”

If your pension scheme offers lifestyling, you may have escaped the worst of the crash.

“Lifestyling involves gradually shifting your money out of risky equities in the five years before you retire and into safer cash deposits. If your scheme has done this you don’t need to wait for a recovery,” Bayliss says.

People who defer taking an annuity rarely enjoy dramatically better benefits, warns Tim Whiting, director at the Alexander Forbes Annuity Bureau.

“Every month that passes without taking income represents a loss. You might get this back if your fund’s valuation or annuity rates improve but that isn’t guaranteed.”

And you shouldn’t bank on annuity rates ever reverting to their heyday.

“But compared with returns on savings they are still competitive,” Whiting says.

Shop around

Whenever you buy your annuity, the most important thing you can do is shop around for the best deal.

Taking the open market option, as it is called, can boost your annuity income as much as 20 per cent, which means you get 20 per cent extra income every month for life.

Almost six out of 10 people still think they are obliged to buy their annuity from their pension provider, according to new research from Intune, the financial services company owned by Age Concern and Help the Aged.

And more than half believe you can switch annuity if you find something more competitive later, says Mervyn Kohler, special adviser at Age Concern and Help the Aged.

“They aren’t aware that when you have purchased an annuity, it is for life.”

Inflation-proofing

You also have to decide whether to take a level annuity, where your income remains the same for the rest of your life, or an escalating annuity, which keeps pace with rising prices.

The vast majority still choose a level annuity, because the initial income is up to 25 per cent higher.

But over time its value will be eroded by inflation, whereas an index-linked annuity will steadily increase, says Bayliss.

“If you can afford to take the lower income initially, an escalating annuity gives you valuable protection.”

It might be worth taking independent financial advice from somebody who really understands the pensions and annuity market.Here is a rare piece of good news for people who smoke, are overweight or suffer from a serious illness: they may get more income from their annuity.

Impaired or enhanced life annuities may pay higher income because poor health reduces your life expectancy, which means the annuity company probably won’t have to pay you for as long.

Up to 70 per cent of people don’t realise they may be able to get a higher income by revealing their medical conditions, says Steve Hunt, managing director at annuity specialists Rockingham Retirement.

“A lifelong smoker with a £50,000 pension pot and Type 2 diabetes could increase his pension income from £3,163 a year to £3,714, a rise of 17 per cent.” That works outs as an extra £551 a year, or £46 a month.

Jack Graham, 70, boosted his pension income after seeking out impaired life annuity specialists Partnership Assurance.

Jack, who lives with wife, Carol, in Winchmore Hill, north London, had undergone major heart surgery, and realised that he might qualify for an enhanced annuity. “My financial adviser hadn’t even heard of impaired life annuities, which were new at the time.

“I had to do the research myself. It has boosted my income by at least 10 per cent.”

Four out of 10 people may qualify for enhanced rates, yet just one in 10 buys an impaired life annuity, also sold by LV, Norwich Union, Prudential and others.