Falling Interest Rates Are Bad For Your Pension

If you're thinking about taking an income from your pension soon, find out why falling interest rates are bad news.

For a while there it looked like the credit crunch was going to give pensioners a bit of good news. As I explained in this article, annuities -- which convert your pension into an income -- have become more generous in the financial crisis and are at their highest level for six years.

But, sadly, it seems this glimmer of hope is going to be pretty short-lived. And that's all thanks to falling interest rates. While reductions in the Bank of England base rate should be a positive move for borrowers, the reverse is true for those of you who want to buy an annuity.

How are annuities backed?

Annuities come in all shapes and sizes but, to keep things simple, I'm going to talk about standard annuities which provide you with a fixed level of income for the rest of your life.

Most pension experts agree standard annuity rates now look set to slide over the coming months. This is all to do with how annuity companies pay your pension income.

To guarantee that your annuity keeps paying out for as long as you need it, annuity companies need to invest the pension pot they take from you when you buy your annuity. This money is usually invested in a combination of gilts and corporate bonds.

What are gilts and corporate bonds?

In simple terms, a gilt is essentially a loan to the government. In return the gilt investor -- in this case the annuity company -- receives a fixed rate of interest. Gilts are considered to be a very safe asset because the risk of the government defaulting -- in other words, where it is unable to pay back its debts to its investors -- is extremely low.

Corporate bonds are pretty similar to gilts except that they are loans to companies rather than the government. Because the probability of a company defaulting is higher than the government, the rate of interest paid is normally higher to compensate for the added risk to the investor.

Why are falling interest rates bad for your pension?

As the credit crunch hit, the cost of borrowing rose sharply. This forced companies to increase the interest paid on their bonds to encourage nervous investors to hand over their cash. This was great for the annuity companies who began to earn more income from the new bonds they bought, allowing them to increase annuity rates across the board for new customers.

But when interest rates fall -- as they are now -- the interest payable from gilts and bonds will drop too. It's already starting to happen with the yield on 10-year gilts crashing below 4% for the first time since January 2006. If interest rates fall further -- as many predict -- gilts and bonds are likely to offer an even lower income to investors who buy new issues.

As we have seen, annuity companies use the interest earned from bond investments to underpin the income payments from annuities. So it follows when the annuity companies get less income, so will annuity customers.

What does all this mean if you need to buy an annuity?

First of all, let's take a look at annuity rates now:

Annuity rates - based on a pension pot of £100,000

Source: The Annuity Bureau. Figures are based on a purchase price of £100,000 and provide a level annuity with no guarantee period.

The most competitive annuity is currently offering a 65-year old male an annuity rate of 7.85%, while a 65-year old female could get 7.43%. However, advisers predict these rates could fall by as much as 10% over the next year. This means a 65-year old male would -- all things being equal -- get a rate of just 7% or so at best, reducing his annual income by roughly £850 a year.

So it's more important than ever to choose the right type of annuity at the right time. Take a look at the helpful hints below.

Very quick guide to buying annuities

Your annuity will pay out an income to you for the rest of your life. Once you've bought an annuity, the decision can't be reversed, so you only get one chance to get it right.

There's certainly a case for locking into an annuity now before rates drop any further. But it isn't quite that clear cut. You might not be keen to buy an annuity today if weak stock markets have caused the value of your pension pot to drop.

Here are a few of my suggestions on how to protect your pension from falling stock markets including some alternatives to buying an annuity now.

If you have to buy an income from you pension right away, here are some Foolish ideas on how to buy the right annuity. You might be surprised how much extra income you could enjoy.

These articles might help too:

Get 12% more from your pension the easy way suggests a simple way to squeeze a higher income out of your pension fund.

Give your pension an £11,000 boost explains how to beat inflation in retirement and,

Enhance your pension income by 25% gives the lowdown on enhanced annuities.

Best of luck, Fools.

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