Are you doing enough to find a richer retirement? Exploring all options is vital to protect pensions against scourge of inflation

Experts are urging anyone turning their pension funds into retirement income to explore all options, amid fears that too many are locking into poor-value lifetime annuities that provide no protection against inflation.

They say most people opt for annuities that pay a level income throughout retirement and are ignoring better alternatives that allow it to grow. Those with pension pots of £50,000 or more are losing out the most.

This is despite rules introduced last month to ensure that more people end up buying the right annuity. And worryingly, it is happening as an increasing number of retirees with ‘defined contribution’ pension funds – either personal or through work – are forced to decide how to turn their money into income.

SCROLL DOWN FOR THE 5 WAYS TO TURN A PENSION FUND INTO A RETIREMENT INCOME

Onwards and upwards: Martin Spring plans to use his pensions to finance his hobbies of cycling and mountain trekking

About £14billion of pension funds every year are turned into lifetime income, but this sum is expected to grow by 15 per cent a year, a result of the shift in the workplace away from gold-plated final salary schemes. Billy Burrows, one of the country’s top pension annuity experts, is leading the charge to ensure more people think ‘outside the conventional annuity box’.

Burrows has co-written a report – Annuities At A Tipping Point: The Case For Investment Linked Annuities – with Professor John Maule, emeritus professor at Leeds University Business School.

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He is extremely concerned people are not being encouraged to think long term when deciding what to do with their pension pot. ‘Most of us will live for between 20 and 25 years in retirement, some even longer,’ he says.

‘On that basis we need to think about how best to protect our retirement income against the ravages of inflation. The solutions all involve risk, but for some they are worth taking.’

According to the latest data from the Alliance Trust Economic Research Centre, the over-75s face the highest level of inflation, primarily a result of punishing increases in energy bills.

Fears: Report author Billy Burrows

Until recently, a majority of those with defined contribution pots opted for the annuity offered them by the manager of their fund – usually an insurance company. Typically, this was set up on a single-life basis with income payments staying the same throughout retirement.

But new rules introduced by the Association of British Insurers encourage everyone to shop around for a higher-paying annuity using the open market option.

They also alert retirees to the importance of providing protection to loved ones through buying a spouse’s pension and the availability of annuities that pay higher income because of poor health or a history of drinking or smoking. Although these rules will help people to make better retirement income choices, Burrows, who works for London-based retirement income specialist Better Retirement, believes they do not go far enough.

‘Shopping around for the best-paying annuity is just the tip of the iceberg,’ he says.

‘We need to get people out of the mind-set that drives them to look for the highest starting income when a better approach would be to consider other options that provide a high starting income but with the potential for future income growth.’

Burrows now questions whether conventional annuities should remain the default option for Middle Britain.

Alternatives to conventional level annuities include those where payments rise in line with inflation or a set amount per year. These remain unpopular because of the low starting income, although they can prove a winner if you live longer than 15 years after retirement.

Investment-linked annuities are also an option. Offered by insurance companies LV=, MGM Advantage and Prudential, they give retirees the opportunity to benefit from growing income.  

However, this is not guaranteed and depends on the underlying investments performing well. Indeed, income can fall. Other unconventional options include income drawdown and fixed-term annuities.Burrows says that anyone who is considering these riskier options must observe three golden rules.

‘They should only consider them if they have other sources of guaranteed income,’ he says.

‘They also need to understand the risks involved and that income may fall as well as rise.

‘Finally, they have to be aware of all options. Provided they do this, they should end up making the right choice.’

 

Martin Spring, 67, a freelance architectural journalist from Islington, North London, has a portfolio of pension pots – some work-based, some personal – which he is gradually converting into a lifetime income.

So far, he has used one fund to buy an annuity from Just Retirement, which increases payments by three per cent a year. He has used another to buy an investment-linked annuity with MGM Advantage.

Martin, who is single, says: ‘I want to convert my pensions in stages and consider all options. I want to enjoy my retirement and pursue my hobbies of cycling and mountain trekking. That means ensuring my pension funds deliver a rising income.’

FIVE CHOICES TO NURTURE A £100,000 FUND

Someone wanting to turn a pension fund into a retirement income has five options. Take the case of a man aged 65 with a £100,000 pension pot after tax-free cash. He has a wife aged 60. They want monthly income with a two-thirds spouse’s pension.

1.) The most popular option is to buy a level annuity. This would yield a gross annual income, paid monthly, of £4,843. But payments are fixed, thereby providing no hedge against inflation. But there are alternatives.

2.) An annuity rising in line with RPI. Currently, the starting gross annual annuity would be much lower at £2,738, but it would increase over time. If inflation was 3.5 per cent  a year, it would take 18 years for payments to overtake the level annuity of £4,843. At four per cent, the catch-up period is 16 years.

3.) An annuity where future increases/decreases to income payments depend on investment returns. The couple could choose from one of three investment-linked annuity routes. They could opt for a maximum starting annual income of £6,017. This would be maintained provided the underlying investments grew at least five per cent a year.

If performance was less than five per cent, the annual income would be cut. Above five per cent, it would rise (by any growth above five per cent).

Alternatively, the couple could take the same starting income as available under the level annuity option (£4,843). Income would then rise provided the underlying investments grew by at least 3.28 per cent. It would fall if the 3.28 per cent growth was not achieved. Or they could opt for a minimum income of £2,857. Here any investment growth would be replicated by growth in income.

4.) The couple could consider keeping their pension fund invested while drawing an annual income. The maximum income under this income drawdown option is £6,720.

5.) Or they could buy a short-term fixed annuity (five years) and then at the end of the period lock into a lifetime annuity (hopefully when annuity rates have improved).

They could take annual income for five years of £6,720, leaving a pot of £70,995 after five years to convert into  an annuity.

Or they could take £4,625 annual income leaving a pot after five years of £82,658.