A rotten year to retire

2011 will be a rotten year to retire for many people. Here are a few ways to lessen the pain.

If you’re retiring in 2011, I feel sorry for you. Or, more accurately, there’s a good chance I’ll feel sorry for you.

If you’re one of the lucky ones who are retiring with a final salary pension, then you have nothing to worry about. Stop reading this article now and do something more fun!

But if you have a defined contribution pension (a.k.a money purchase pension), then things don’t look so good.

Investment performance

The first problem is that the stock market hasn’t performed well over the last decade.

At the end of 1999, the FTSE 100 index (‘Footsie’) peaked at 6930 points. As I write, the index is at 6058. So if your pension pot has been partly or wholly invested in shares, it won’t have grown by much. (Even though the Footsie has fallen, your investment has probably grown in size. That’s because the Footsie index doesn’t include dividend payments.)

This poor investment performance means that the size of your pension pot is probably smaller than you might have hoped for ten years ago. A smaller pension pot means you’ll have less money with which to buy an annuity.

Low annuity rates

This is the biggest problem for 2011 retirees. For a single 65-year old man, annuity rates have tumbled from around 15% at the beginning of the 90s to around 6% now. In 1990, a £100,000 pot could have secured you an annual income of £15,000. In 2011, you’ll only get £6,000 a year. (These rates are for level annuities. In other words, your income stays the same for the rest of your retirement and doesn’t rise in line with inflation.)

The fall can partly be explained by longer life expectancy. Technical changes to make insurance companies more robust have also made a difference.

But the most important factor has been falling yields on gilts (government bonds.) Annuity rates are closely linked to gilt yields, which are mainly driven by what investors expect to happen to inflation. Inflation is lower now than in 1990, and inflation expectations are lower too. As a result, gilt yields are lower and so are annuity rates.

Defenders of annuities would argue that today’s lower annuity rates aren’t as bad as they seem because a pensioner retiring now will experience less inflation than one who retired in 1990.

That’s fine in theory, but, in practice, I think it’s bunkum. For starters, the market’s expectation of future inflation could be wrong. What’s more, the linkage between gilt yields and inflation expectations may well have broken down in the last couple of years. That’s because the Bank of England has been ‘printing’ billions of pounds of new money since May 2009, and has been using that money to buy gilts. The extra demand has pushed up the price of gilts, and yields have fallen. That’s in spite of the fact that many pundits think inflation will rise this decade.

So there’s a real danger that you could buy an annuity now and then see its value erode very quickly as inflation picks up.

Solutions

So if you’re planning to retire this year, what can you do? I’ve got five possible solutions for you:

1) Shop around!

This is the most important one. When you buy an annuity, it’s essential that you compare annuity rates across the market and get the best deal you can.

2) Buy an investment-linked annuity

If you buy one of these annuities, your pension pot is effectively still invested in the stock market. This means that your annual income can rise if the stock market rises. On the other hand, if stock markets fall, your income will fall too.

3) Defer your pension

Don’t buy your annuity now! Wait until market annuity rates (hopefully) rise. What’s more, you’ll be older when you eventually buy an annuity and you’ll get a higher rate in return for the fact that you’ll live for a shorter period.

This strategy could work well. The downsides though are pretty obvious. You’ll need an alternative source of income to keep you going until you buy your annuity. Even more important, annuity rates could fall further instead of rising.

4) Income drawdown

Income drawdown is another way to put off buying an annuity or even not buying one at all. Basically, you can leave your fund invested and draw an income from it each year. It’s also known as USP (Unsecured Pension.) The rules on income drawdown have changed recently and this option is now more attractive for some people. Find out more in Why your retirement just got better.

5) Buy a temporary annuity

A temporary annuity can be bought for a fixed period, usually a minimum of five years and a maximum of the period until age 75 is reached. The annuity income is set for the period and at the end of the period, a portion of the original pension pot is still available for the pensioner. This can be used to buy another annuity or for income drawdown.

I’m not claiming that any of this is simple. So if you’re at all uncertain, it's probably best to consult an Independent Financial Adviser (IFA). Before you see your adviser, it's worth looking at your whole financial position. You'll need to consider such questions such as:

- Will you have any other sources of income when you retire?

- Do you own your own home?

- What kind of lifestyle do you want to have in your old age. How much will it cost?

Then you'll have the best chance of ensuring that 2011 isn't a rotten year to retire after all.

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