Will deferring your retirement for the next few years really destroy your pension income?
There are many financial decisions you’ll be faced with as you near the end of your working life. One of the most important is when you should actually retire. For most of us it’ll be a case of retiring later rather than sooner, with the coalition government planning to push back state pension age at the earliest possible opportunity.
Most of you will buy an annuity when you reach retirement which will convert your accumulated pension fund into a guaranteed income for the rest of your life. Annuity rates are determined by many factors, but one of the most important is your age.
If you buy an annuity at a relatively young age, your annuity rate will be lower because you’re expected to receive an income for a longer period compared with someone who delays their retirement.
The big question
So this begs the question: Is it better to buy your annuity at a younger age and take a lower income over a longer period. Or, if you retire later, is the reverse more attractive in providing you with a higher income for a shorter period?
Which option makes sense financially? Let’s find out…
According to the Office for National Statistics (ONS) life expectancy for men aged 65 now is around 83 years. So, if you retire at 65, you can expect to reach your 83rd birthday and spend a total of 18 years in retirement.
Imagine you’re 65 and you buy an annuity today with a pension pot worth £100,000. The most competitive standard level annuity would provide you with a guaranteed fixed income of £6,380 every year. This is equivalent to an annuity rate of 6.38%. However, if you deferred retirement until you reached your 70th birthday, you would enjoy a higher annual income of £7,350 - which is an annuity rate of 7.35%.
So, if you chose to retire at 65, and you survive another 18 years, your annuity would pay out £114,840 in total. However, if you decided to defer until you reach 70, and you survive another 13 years until your 83rd birthday, the total payout from your annuity would be just £95,550.
By retiring five years later, you’ll lose £19,290 despite the higher annuity rates you’ll be eligible for at the age of 70. Putting it another way, you could lose a chunk worth almost 17%.
This tip is absolutely vital to know if you want to make the most of your pension pot at retirement.
A missing piece of the jigsaw
On the face of it, holding off retirement doesn’t seem like a particularly savvy move. After all, if you start taking benefits at 70, you won’t even get back the full value of your pension pot if you live to reach normal life expectancy of 83.
But there’s a piece of the jigsaw missing here because these figures assume a £100,000 pension pot at 65 will still be worth exactly the same amount at 70, which is highly unlikely if you leave your pension invested for another five years before drawing benefits.
Let’s say, during this deferment period, your pension pot grows by another 7% each year (with 1% deducted annually to cover management charges). In this scenario, the fund could potentially be valued at £133,823. Using the same top annuity rate at age 70 of 7.35%, your annual income would increase to £9,836. Surviving for another 13 years means your total annuity payout would now be £127,868.
So this time, you would actually be £13,028 better off by deferring your pension rather than taking it at 65 - which means you have gained an extra 13% above and beyond the value of your pension pot at 65. But you’ll probably have noticed that the total income you take from your annuity still falls short of the final pension fund value of £133,823.
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Pension growth
Now it looks like deferring may actually be more beneficial than retiring at 65. But all this comes with one potentially huge drawback: what if your pension fund doesn’t grow at a rate of 7% a year?
At one time 7% was deemed a reasonable rate at which pension funds were likely to grow. In fact, pension projections were based on this figure. But the performance of many pension funds over the last few years hasn’t even approached this level. Clearly, the benefits of deferring will become more diluted if the pension fund itself grows at a slower rate. Or, more worryingly, if the pot actually falls in value over the five-year period, you'll be even worse off compared with retiring at 65.
Despite this obvious risk the popularity of unsecured pensions (formerly known as income drawdown) has gone through the roof. These arrangements enable you to continue investing your pension, but draw an income at the same time if required.
Annuity rates in the future
Not only do you need to consider whether it’s worth taking a gamble on your pension value increasing sufficiently to offset the income you’ll lose by deferring, but you’ll also need to think about the prospects for annuity rates in the coming years.
Right now annuity rates have hit all-time lows giving pensioners increasingly reduced levels of pension income. If annuity rates were to fall significantly again over the next five years, the margin between rates for a 65-year-old and a 70-year old would become much narrower, making the case for deferring even weaker.
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