Pensions are getting bigger!

Good news if you are about to retire! Pension incomes are at a two-and-a-half year high.

If you’re about to retire, I have some good news for you. Pension incomes for many new retirees are on the up. However, you’ll still be worse off than many folk who retired in the 90s.

I should add that the recent good news only applies to people who have defined contribution pensions. This is where you and/or your employer make contributions to a pension pot during your working life. That pot is then used to buy you a pension when you retire.

Let’s imagine you’re a 65 year-old man and you retired this month. You’ve paid £100 a month into a pension fund for the last 20 years. All of your contributions have been invested in a pension fund that invests in a mix of shares and bonds.*

Based on average figures from Moneyfacts, your pension pot would now be worth £41,964. If you had used that pot to buy a level annuity this month, you would have acquired a pension of £2,639 a year for the rest of your life. That’s not a big sum, but it’s better than what you would have got two years ago – £2,236 a year.  In fact, average retirement incomes now stand at a two- and-a-half-year high.

So why have payouts increased slightly?

It’s mainly because the stock market has had a good run over the last two years. On top of that, annuity rates have edged up over the last year. Look at the figures at the bottom of this table for 2009 to 2011. Rising share prices have boosted the average pension fund from £34,736 in May 2009, to £41,964 now!

Source: Moneyfacts

Meanwhile the average annuity rate has edged up from £620 to £629 over the last year.

Annuity rates are primarily driven by two factors: life expectancy and long-term interest rates, and it’s long-term interest rates that have made the difference over the last year. These long-term rates have risen as worries about inflation have increased. (If you want an explanation of how long-term interest rates work, read a note at the bottom of this article.)**

The future

So what will happen next? My view is that the worries about inflation may subside a little over the next couple of years, so annuity rates may fall a little. As for the stock market, it’s very hard to predict, but my best guess is that it will move sideways over the next couple of years.

That means that if you think you may want to buy an annuity over the next couple of years, now could be a good time to do it. However, my predictions may be wrong, and anyway, if you’re unsure, it’s probably best to take advice from a good financial adviser.

What’s more, an annuity isn’t the only way to convert a pension pot into an income. Find out more in Become a pensions expert in five days – day three.

The past

So far in this article I’ve only written about the last two years or so. If you look at the above table, you’ll see that the story since the mid-90s is not a happy one. Even after the recent rises, pensioners who retired 15 years ago got a much better deal than anyone who retires now. The 65-year old man who retired in May 1996 would have got an annual income of £13,327 compared to £2,639 now. That’s a shocking decline.

People who retired in the 90s had much bigger pension funds and also benefitted from higher annuity rates. They were fortunate that the stock market had a very good run in the 80s and early-90s. And annuity rates were higher because inflation expectations were a fair bit higher back then.

When you look at the figures for the last couple of years, it’s tempting to say that saving for your retirement is a waste of time. However, as life expectancy gets longer and longer, we should resist that temptation. I believe that just about everyone who is in paid employment should save for their old age.

Yes, I accept that buying an annuity can be a bit of a lottery, but you don’t have to focus on saving into a pension if you don’t want to. Instead you could save into an ISA or you could invest in property. (Although I think it’s a mistake to put all your eggs in the ‘property basket’).

That said, I think you’d be mad not to save into a pension if your employer will make matching contributions into your pension. And you could at least take comfort from the fact that pensions have moved up a little over the last year or so....

*   The fund is a typical Mixed Investment 40%-85% Shares pension fund. (This sector used to be known as balanced managed.)

**  Long-term interest rates reflect the price of government bonds. These bonds normally pay a fixed sum when the bond matures. If you think that inflation is going to rise, you’ll pay less to buy the bonds now. That’s because the fixed sum will have a lower real value if prices have risen a lot. If government bonds are cheap, long-term interest rates are high and vice versa.

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