Your Retirement Choices Unravelled

Posted on: 14 April 2008 by Gareth Hargreaves

Wondering what the best way is to fund your retirement? Pensions Analyst Nigel Callaghan explores the options.


If you are planning to retire in the next few years, you may be thinking about how to take an income from your hard-earned pension savings. Given that pension funds are often one of the largest assets an individual has, it's vital that all the options are understood.

This article aims to shed some light on these choices.

Annuities

Until the mid 1990s, the only real choice for anyone with a maturing pension plan that wasn't a final salary scheme, was to buy an annuity.

Annuities came in differing shapes and sizes - single or joint life, with or without inflation proofing - but they weren't that exciting.

I do think the ordinary annuity is a much better product than many give it credit for. It does one thing very well; it guarantees you an income for the rest of life, no matter how long that is. Nothing else does this. The virtue of such a guarantee is that it leaves you with more flexibility to manage the rest of your money creatively, secure in the knowledge that your annuity will keep paying out.

Golden Rule

Annuity rates vary enormously between insurers. Retiring investors should always shop around to ensure that they get the highest annuity rate they can amongst insurance companies - this can be easily done by using web-based annuity comparison sites or by seeing an Independent Financial Advisor, who specialises in annuities.

The annuity your existing pension company offers you may represent dreadful value for money. On average, an investor can improve their pension income for life by over 15% by shopping around. As the typical 65 year old will live for another 20 years plus, this additional income can easily amount to thousands of pounds.

This is a once-off decision, so get it wrong and it could prove to be an expensive oversight.

The following table highlights the best-buy deals, based on a fund of £100,000. These deals change frequently, so ensure you always get the most current rates available.

Male

Female

Age 60; Level pension

£6,726

£6,378

Age 60; RPI-linked pension 

£4,033

£3,672

Age 65; Level pension

£7,459

£6,974

Age 65; RPI-linked pension

£4,768

£4,311

Source; Hargreaves Lansdown

Do annuities represent good value?

In the short term, rates are near a 4 year high, so many investors consider this to be a good time to buy an annuity. Bond yields have significantly widened in the wake of the credit crisis, which has been helping to push up annuity rates. There also seems to be a fierce price war amongst the top annuity insurers. The consumer should be the winner from this.

Which way for future annuity rates?

There is a mixed outlook and the future direction of annuity rates is not clear;

Interest rates and inflation are at historic low levels. Annuities have looked like pretty poor value compared to the high payouts of yesteryear. An income today of 7.5% looks much less fun than the 14% available in 1990.

We are all living much longer and insurers have lowered rates to reflect this. Life expectancy at age 65 has risen at a rate of three months a year over 25 years, adding several years on to the average annuity payment period. This is set to continue, with a corresponding knock-on effect of lowering of annuity rates.

Rising commodity prices and the credit-crunch are causing real inflationary fears that could push annuity rates up.

We might look back on 2008 as an annuity highpoint.

Enhanced Annuities

Some insurers will pay a higher income if you have certain medical conditions. Statistics show that people with some health conditions have a shorter than average life expectancy. These specialist insurers use this to your advantage: they will pay you a higher income because they calculate that, on average, your income should be paid out for a shorter period of time.

About 40% of people could obtain enhanced rates, yet only a tiny proportion apply for them. Don't miss out.

It might seem couter-intuitive, but you should paint the blackest (but truthful) picture of your state of health. Declare any lifestyle or medical conditions as they may qualify you for an even bigger income. If you smoke 20 cigarettes a day, shout about it.

Everyday conditions - 1500 and rising - including being overweight, high blood pressure or diabetes could qualify you to an enhanced annuity and its higher income for life.

Here's examples of the rates available for relatively minor conditions, based on a £50,000 fund for a 65 year male (single life, no escalation or guarantee).

Annuity p.a.

% Increase over ordinary annuity

Ordinary Annuity

£3,719

Smoker

£4,447

20%

Enhanced annuity, based on high blood pressure, cholesterol and obesity 

£4,245

15%

Source; Hargreaves Lansdown

Income Drawdown

This is an alternative to buying an annuity. You draw an income directly from your pension fund, whilst the fund remains invested. It allows you to retain ownership of your investments.

You continue to manage your pension fund and make all the investment decisions. Providing the fund is not depleted by income withdrawals or poor investment performance, it may be possible to increase your income.

However, there are no guarantees. If your pension savings are decreased by withdrawals or poor performance, your income will be reduced. You bear the investment risk - unlike an annuity. You need to be happy to accept this risk. If you're not, it may be sensible to buy an annuity instead.

The maximum income you can take from a drawdown plan is 120% of whatever an annuity will pay, whilst the minimum is zero.

Investors can withdraw their tax free cash sum at age 50 (55 from 2010), and leave the balance of their pension fund invested and growing until they need it, perhaps ten or fifteen years later. Given recent stockmarket turbulence, some investors have been doing this as way of generating income for the next few years, but leaving the majority of their pension savings intact and invested in the hope that the markets will recover.

Inheritance Considerations

Death benefits for drawdown plans are a definite attraction, compared to the relatively inflexible terms of an annuity. An annuity's main problem is that once you have made your choices, you are stuck with them forever. With drawdown, nothing needs to be decided in advance. On your death, your surviving spouse has the choice to carry on with the drawdown plan as if it were their own; take the entire fund and buy an annuity for themselves; or take the fund value as cash, less a 35% tax charge.

Future Investor Retirement Strategies

As mentioned, there is a growing trend towards a segmentation of the annuity market. We have even seen postcode rates, on the basis that people in Kensington do, on average, live around 11 years longer than the inhabitants of Glasgow, districts of which have roughly the same life expectancy as the Gaza strip.

If you are healthy and wealthy, then you are going to be increasingly disinclined to purchase a conventional annuity in your sixties; put crudely, you may be better off waiting until your mid seventies, when your health starts to deteriorate, and you may secure a better rate via an enhanced annuity. Until then, you may choose to stay invested in a drawdown plan, managing your investments.

Next Steps

If you are comfortable with making your own financial and investment decisions, there are a number of companies that will offer fantastic value for money for both annuities and income drawdown plans. Some will offer top notch investment research and state of the art web-based service. Any web-engine search will throw up a number of possible candidates. However, if you unsure or need advice, make sure you see an appropriately qualified IFA.

Nigel CallaghanAbout The Author

Nigel Callaghan is a Pensions Analyst at Hargreaves Lansdown, independent financial service provider and asset management specialist.

Further Information

For information on ISAs, SIPPs, funds and share dealing you can call Hargreaves Lansdown's Helpline on 0117 900 9000 or visit: www.h-l.co.uk

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