Why now could be a good time to take your pension

Is it better to buy your annuity now or wait? It's never an easy decision, but find out why you should think about taking the plunge now before rates get even worse.

When you retire, the chances are you’ll buy an annuity which converts your pension pot into a guaranteed income for the rest of your life. The amount of income you’ll get will be influenced by prevailing annuity rates at that point. The idea is, when the time comes, you’ll track down the most competitive annuity you can find because this translates into a higher income in retirement.

When should you buy an annuity?

It sounds simple enough, but choosing when to take benefits from your pension can be a really crucial decision, and one which you must get right. After all, once you have chosen an annuity, it can’t ever be changed.

For some of you there will be no choice but to buy an annuity as soon as you stop working if you have no other sources of income or capital. But if you can afford to wait, should you?

This is a particularly difficult decision for those of you who are thinking of retiring now, because annuity rates recently hit a record low, which means the income paid from your pension will be depressed.

Why are annuity rates so low?

Like all financial products annuity rates are heavily influenced by several economic factors. In particular, they are affected by prevailing interest rates and the yields on government gilts and corporate bonds.

As you’ll know, interest rates have fallen dramatically since October 2008, and the base rate is currently stuck at the lowest level in its history, where it has been for the last 16 months. When interest rates are dropping, annuity rates are forced down too.

When you hand your pension money over to an annuity company, your pot will be invested to provide you with a guaranteed income until the day you die. Your money is put into a range of assets but most commonly government gilts (essentially loans to the government) and corporate bonds (higher-risk loans to companies).

The yields paid on gilts and corporate will have a major effect on annuity rates. When interest rates fall, the yields paid on these assets will drop accordingly. Low yields mean annuity companies are effectively getting a lower return on their investments. So, the annuity rates they offer will also deteriorate. Ultimately, this means when you buy an annuity, the amount of income you receive from it will also be reduced.

Quantitative easing

The Bank of England’s quantitative easing (QE) programme has also taken its toll on annuity rates. The purpose of QE was to increase the money supply enabling the Bank of England to buy assets from the banks. This was intended to provide a cash injection to kick start lending to borrowers which had become heavily restricted during the credit crunch.

The Bank of England bought bank huge quantities of gilts from the banks to provide the much-needed cash. But this measure reduced the supply of gilts which naturally made gilt prices go up. This, in turn, forced gilt yields down.

Again low gilt yields put downward pressure on annuity rates, and this means less income for you.

Stock market returns

Against a backdrop of falling annuity rates, pension values have also suffered in recent years as a result of weak stock market performance. Quite clearly, the smaller your pension pot is at retirement, the lower the level of income you’ll be able to squeeze out of it.

This really is a double whammy of bad news for soon-to-be pensioners who not only have to cope with deteriorating pension values, but are also faced with the impact of low annuity rates on their pension income too.

Recent question on this topic

• The Democrat asks:

  Rules on 'any spouse' quotes from annuity providers after transfer from final salary scheme?

  • 
    MikeGG1 answered "I presume that you are trying to do an Open Market Option (OMO). That is a replacement..."
  • 
    The Democrat answered "Hi Mike Many thanks for your response. A bit more detail... I have just opted out of the PCSPS,..."
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So why on earth buy an annuity now?

With all that taken into account, now doesn’t sound like a particularly good time to commit to an annuity for the rest of your life. But there are other factors to throw into the melting pot. Although, it’s exceptionally difficult to tell how long it might take for annuity rates to recover, there are reasons why they may deteriorate first, before improving. Here are two primary reasons why there may be worse yet to come:

New solvency rules

Firstly, new EU legislation is due to come into force on 1 November 2012, which will increase the capital reserves all EU insurance companies - including annuity providers - are required to have by law. The new directive - known as Solvency II - is designed to increase consumer protection by ensuring that insurance companies are more financially stable than under the current solvency rules.

This sounds like a sensible move - after all, nobody wants a repeat of the Equitable Life debacle - but increasing capital adequacy could have a negative impact on the annuity rates insurers are able to offer since there will be less cash available to invest than before with greater reserves required. This could render annuities even worse value than they already are.

Unfortunately, experts can’t agree how big the Solvency II effect might be, but some estimate annuity rates could be reduced by as much as one-fifth.

Increasing life expectancy

Secondly, according to the Office for National Statistics (ONS), life expectancy in the UK is increasing at its fastest ever rate. If we’re all living longer, annuities will need to pay out for many more years, placing a greater financial commitment on the annuity provider. Remember, annuities are guaranteed to pay out for life.

If providers begin to factor in rising life expectancy when setting pricing for annuities now, it could lead to lower rates still.

Should you buy your annuity now before matters get worse?

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Unfortunately, there’s no clear cut answer here, particularly since we don’t know the full impact of solvency requirements and increasing life expectancy on annuity rates.

There’s an also an equally strong case for waiting. For instance, if your pension pot has deteriorated in recent years, there’s certainly an argument for leaving it invested to allow time for the value to recover.

Additionally, older people benefit from higher rates because their annuity is likely to pay out for a shorter period. So deferring income for a few years will have a positive effect on your rate. That said, you’ll be unlikely to make up the income you miss out on during those deferred years.

Finally, when interest rates eventually recover and the yields on gilts and corporate bonds improve, this should lead to better value annuities. But we can’t tell whether the uplift will be sufficient to outweigh all the factors which could depress annuity rates in the mean time.

More: 12 million face pension cuts | Why delaying your pension make sense