How to avoid rubbish annuity rates

If you don't want to get stuck with the lowest annuity rates in history, here are five alternatives.

If you’re one of the first baby boomers, your 65th birthday is just around the corner which means retirement looms. You’ve probably already thought long and hard about how you’ll pay for your lifestyle once you stop working.

Annuity rates hit an all-time low

Most of you will buy an annuity which converts your pension into a guaranteed income for life. This approach has worked well over the years. But the trouble is, annuity rates - which determine how much income your pension can generate - have hit an all-time low. This means the same pot will yield a lower income than it did before. In fact, today’s annuity rates are now almost half of what they were in the nineties.

And the pain continues as retirement income specialist MGM Advantage, recently revealed standard annuity rates have fallen again, dropping by 6.98% since June 2009. In money terms, men with a pension worth £50,000 could be over £11,000 worse off during retirement, while women could lose almost £10,000 directly as a result of poor annuity rates.

Fortunately, pension rules have changed so you’re no longer obliged to buy an annuity by the time you reach 75. This opens up new opportunities for financing your retirement, but you must start taking benefits in one form or another by this time.

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If you want to take tax-free cash from your pension - many schemes enable you to take up to 25% of the fund tax-free - this must be done before you reach 75 too.

But for those of you who don’t want to lock into low annuity rates, here are five alternatives to consider:

1. Unsecured pension

Unsecured pension or USP is the new name for income drawdown. USP allows you to take an income directly from your pension while the fund remains invested. USP also gives you the option to increase or decrease income as your requirements change. This option is available until the age of 75. (After 75 you have the option to move into Alternatively Secured Pension or ASP which is broadly similar, although more restrictive.) You can buy a lifetime annuity with your remaining fund at a later stage if you wish.

This may be the right option for you if…

• You can accept a varying income.If your pension fund performs well during your retirement you may be able to take a more generous income than an annuity might otherwise provide. Equally, if the fund value drops you may have to take a reduced income.
• You want a proactive approach - You’ll need to decide how your pension will be invested once you move over to USP. An independent financial adviser can help.
• You’re prepared to regularly monitor the value. There are limits on the amount of income you can take to ensure your pension fund doesn’t deplete too quickly. Your fund needs to last as long as you do.
• You have a reasonably large pension fund. USP is generally only suitable for larger pension funds because of the risks involved.

2. Investment-linked annuities

Investment-linked annuities have the potential to provide a rising income during retirement, and are usually invested in the stock market. This is different from standard annuities where there are no risks (other than inflationary risk to the purchasing power of your income) and the pay-out is fixed.

This may be the right option for you if…

• You can accept a varying income. Your annuity will be invested in an underlying investment fund(s). Depending on how it performs, you may be able to take an income which is more or less than a lifetime annuity.
• You want a proactive approach. You’ll need to decide which underlying funds to invest in, and the level of risk you’re prepared to take on.
• You’re prepared to pay higher charges. Investment-linked annuities are more expensive than lifetime annuities to cover the fund manager’s costs.
• You have a reasonably large pension fund. Like USP, because of the investment risks, this approach is best suited to those of you withbig pension pots.

3. Defer pension benefits

You may be about to turn 65, but that doesn’t necessarily mean you need to start taking benefits straightaway. You can defer as long as you wish, providing you have made a decision on how you’ll draw benefits by the age of 75.

This may be the right option for you if…

• You don’t need an income now. The decision to defer will be based primarily on affordability.
• You think annuity rates might improve. Rates have reached historic lows, but if you think a recovery is on the cards, you may be able to take advantage of future rises. That said, annuity rates are expected to remain low, at least in the short-term.
• You want to benefit from higher annuity rates for older people. Rates will always be more generous for someone aged 70, rather than say 65, because annuity companies anticipate paying an income over a shorter period. But it may be difficult to make up the income you lose during the deferment period even with higher annuity rates. This is especially true if you don’t survive past average life expectancy.

4. Phased retirement

Most personal pension plans can be separated into segments. You can then use each individual segment - or a number of segments combined - to buy an annuity or move into USP at different times.

This may be the right option for you if…

• You want greater flexibility. Phased retirement means you don’t have to take benefits from your pension in exactly the same way, or at the same time.
• You want to avoid locking the whole of your pension into low annuity rates now. This option allows you to avoid this.
• You want a proactive approach. Phased retirement involves more effort on your part as you’ll be taking benefits in stages. Each phase will need to be dealt with separately.

5. The OMO

But finally, for many of you, a lifetime annuity will remain the best way to pay for your retirement. If you opt for an annuity then it's vital you use the 'open market option' or OMO. In simple terms, this means shopping around for the most competitive annuity rate before committing yourself. You can find out more about the OMO in Get more money from your pension.

More: 65% of you can boost your pension this way | Give your pension a £24,000 boost!