How to combat falling annuity rates

Annuity rates continue to fall. But are fixed term annuities the answer?

The last couple of years have posed a number of problems to pensioners, with the historically low base rate hitting the group most reliant on savings very hard.

And a new survey has produced further grim news, with the level of income new pensioners can expect to enjoy falling once again.

Falling annuity rates

When you reach retirement, you are likely to want to use your pension pot to buy an annuity, because an annuity gives you a guaranteed income for the rest of your life.

Unfortunately, the latest annuity index from MGM Advantage shows that annuity rates have fallen over the past three months. According to the firm's survey, conventional annuities have fallen 0.18%, while there has been a drastic fall in enhanced annuities, at a whopping 3.5%.

This is bad news, becaues a fall in annuity rates means that the income you will enjoy in retirement is on the way down. And while average rates are higher than they were at the tail end of last year, over the last few years annuity rates have consistently declined, causing a financial headache for those nearing retirement.

The inflation double whammy

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Seeing the income you can expect each month in retirement falling is bad enough. But couple that with vastly rising living costs and it's a double whammy. And with the Consumer Prices Index of inflation still as high as 4.2%, that's exactly what retirees are facing.

Inflation is painful for working people; unless our salary is increasing alongside it, in real terms our monthly income is decreasing as we are left with less disposable income once all the essentials are covered. However, at least workers have the potential to do something about it, namely ask for a raise or look around for a better paying job.

Things are somewhat more difficult for pensioners – after all, it's not like you have too many options when it comes to increasing your incomes. And the elderly are always hit by inflation harder than the rest of us, given that the things you spend the bulk of your cash on (like gas and electricity bills) are the areas that have seen the sharpest price rises, while you probably haven't benefited from falling mortgage rates the way that the younger population have.

To demonstrate this, Age UK has started tracking the 'Silver RPI', the rate of inflation that really affects older people, and found that since 2008 the over 55s have faced additional costs of £918 per year due to inflation, compared to the rest of the population.

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All of this demonstrates just how important it is to secure the best possible income in retirement. Obviously, saving as much as possible, for as long as possible, helps - as does your choice of pension fund. There's no point saving like a trooper if you then get a dreadful return on that cash.

However, perhaps the most important decision of all is your choice of annuity. Because, despite how it may appear, you do indeed have a choice.

When you get to retirement age, the insurer with whom you have been saving all these years will send you a quote for an annuity from them. And many of us simply accept that quote, and sign up. That's a potentially very expensive mistake, as you can't change your mind and shop around five years down the line – you're committed for the rest of your life.

You only get one chance to shop around with an annuity.

Fixed term annuities

Or do you? Thankfully, there is now an option that allows you a little more time over making such an important decision – a fixed term annuity.

Here's the idea. Rather than sign up to an annuity to cover the rest of your life at the age of 60, a fixed term annuity gives you the chance to take an income over a shorter term, say five or ten years. Then at the end of that term, you can use the remainder of your retirement pot to buy that traditional annuity to cover you for the rest of your life.

There are a few big positives to fixed term annuities. At the moment, annuity rates are really quite low. As such, it's not a great time to buy one. So a fixed term annuity allows you to put that decision off, hopefully until a time when the rates on offer will be a little bit more attractive. Of course, there's no guarantee rates will go up!

The other factor to consider is your health. If you have any health issues, then you may qualify for an enhanced annuity, which pays a higher income. Put simply, the provider reckons you will probably die sooner, so can afford to pay you a higher amount. By putting off purchasing that annuity for an extra decade, it then becomes more likely that when you buy that annuity you will have some sort of health issue which may entitle you to an enhanced annuity.

It sounds terribly morbid, but it's worth taking into account.

The negatives

There are a few downsides to take into account when it comes to fixed term annuities.

First of all, there really aren't many providers offering these 'third-way' annuities. On the plus side, Aviva has recently moved into offering fixed term plans, and other providers are likely to do so in the future. However, for now, there is a very limited choice.

Then there's the gamble you take on annuity rates. Sure, in ten years rates may be higher than they are now. But given the way they have fallen over the past decade or so, who is to say they will not be even lower than they are now? Indeed, new European legislation, in the form of Solvency II regulations, are almost certainly going to cause annuity rates to fall, at least in the short term.

Fixed term annuities are far from perfect, but they do at least offer a more flexible option than is currently the case with traditional annuities. For them to really take off and become a mainstream option, more providers will need to enter the market though. Let's hope the other big players take notice of Aviva's move.

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