Give Your Pension Income A Massive Boost!

Increasing life expectancies will mean our pension pots have to stretch further. Here are some great tips to boost them.

Last week the Financial Times reported that life expectancies have been rising fast over the past seven years, and not slowing as had been widely forecast. This is good news for all of us*, but it's particularly good news if you've recently bought an annuity (a pension income) with your retirement pot.

Pension and annuity providers have been using these forecasts to set their annuity rates. As they've been underestimating our lifespans, they've been giving us higher rates than they otherwise would, because they thought our pots didn't need to stretch so far.

Combined with improving gilt (Government bond) yields, which is the other main factor in setting annuity rates, recent retirees should be relatively happy with the current situation.

That's because once an annuity rate is agreed, the provider can't come back to you and say 'Ever so sorry, but we made a mistake about how long you'll live. We'll have to either reduce your income or stop sending you our computer-generated Christmas cards, because we can't afford both.'

However, when these companies catch up with current data, we're likely to see annuity rates fall dramatically for future pensioners. If providers need to add five more years to our average life expectancy, running some rough figures it looks like they'll reduce the annual income they offer by at least 8%, and probably more like 10%, because they'll want to make up lost profits for underestimating life expectancies in the past.

This means instead of being offered, say, £15,000 per year for your pension pot, you'll be offered £13,500.

Data last year showed a man born in 1950 who lived to be 65 will on average live to be nearly 90, so over the almost 25 years of your life post-retirement, an annuity 10% lower could cost you £35,000 or more.

But there are some things you can do to improve your pension income, other than encouraging your neighbours to die younger. Here are three tips:

1. Shop around for your annuity

The most obvious is to shop around for your annuity. Your own pension provider(s) will offer you one, but you will almost certainly get a far better rate elsewhere.

The difference between the best and worst annuities is about 20%, so instead of accepting the £13,500 your provider offers, you could perhaps get £16,000 per year.

2. Consider different types of annuity

Consider whether a level or escalating annuity is most suitable. A level annuity remains the same for the rest of your life, whereas an escalating annuity starts lower, but increases each year, typically by 3% or by inflation.

I've found that the level annuity starts so high compared to escalating annuities that it could take a 65-year-old as long as 12 or 13 years before his escalating annuity reaches the same annual income.

If you also save part of your level annuity during this time, you can subsidise your later income with it. Doing this you'll probably find your income remains higher than someone who has an escalating annuity for almost 20 years.

20 years takes you to 85. After then, however, escalating annuities will rapidly overtake level annuities.

Choosing between them has to be a personal decision. There are three main things to consider when choosing between a level and escalating annuity:

1. When you have got your best quotes for both level and escalating, you need to work on some figures. If you need help with this, I'm sure our knowledgeable board users will assist you.
2. If you think you'll live for a long time, or you don't want to gamble, an escalating annuity will probably make more sense.
3. However, by the time you're 85, you may think your expenses will be a lot lower. Perhaps you'll do a lot less travelling and going out than you did at 70, so you might not need as great an income anyway. This means a level annuity, again, might be better, but don't underestimate how devalued your income will be after 20 years, due to inflation.

3. Use your tax-free lump sum to get further income

This is pretty complicated. Basically, you could take 25% of your retirement pot as a tax-free lump sum. The remaining 75% you use to buy a pension annuity, as described above. However, with that 25% you could buy a different kind of annuity, called a purchased life annuity.

You can get these as level or escalating, along with many of the other options available for pension annuities.

If you have a £400,000 pension pot, 25% equals £100,000. Purchased life annuities are significantly smaller than pension annuities. A £100,000 pot might buy a 65-year-old a purchased life annuity paying £4,500 per year. Compare this with about £5,000 for a pension annuity.

But the way that purchased life annuities are taxed often makes them advantageous. For a 65-year-old, perhaps 80% of the purchased life annuity might be income-tax free. After tax with a £5,000 pension annuity you'd get £4,000 (or £3,000 for higher-rate tax payers), whereas for a £4,500 purchased life annuity you might get £4,320 (£4,140). That's an improvement of about £300 per year (£1,000 for higher-rate payers). Over 20 years, that's an extra £6,000 (£20,000)!

Although, as I said, it's complicated. You'll need to do your research on purchased life annuities when it comes closer to your retirement date. Again, ask a question on our Pensions - Practical Problems if you need help.

*Except one of my colleagues, who wants compulsory euthanasia at 70...I think he's joking!

> Read The Four-Step Guide To A Comfortable Retirement.