From September, where you live could influence how much income your pension pot makes. We explain why.
What's the point of having a pension?
Put simply, pensions exist to provide income to workers after they retire. How pensions work is that you pay in money throughout your working life. These contributions, together with substantial investment gains made over decades, should create a fairly hefty pot of money. In most cases, this pot of capital is then turned into a guaranteed income for life by way of an annuity.
An annuity is a monthly or yearly income paid by an insurance company to an annuitant until s/he dies, in return for an upfront payment. The big problem with annuities is that, once you hand your pot over, you lose it forever. Thus, an annuity is a gamble by both life insurer and annuitant. If you live considerably longer than mortality statistics suggest, then you win the bet. However, if you die within a few years of buying an annuity, then the insurance company wins.
The level of annuity which you receive depends on a whole host of factors, including your age, gender (on average, women live longer than men), smoker status, marital status, and state of health. Other external factors also have an impact on the income paid, such as prevailing interest rates and whether your annuity income is flat or rises over time.
It's important to note that you do nothave to buy an annuity from the pension company with which you have saved. Indeed, pension companies are legally obliged to inform you of your right to shop around for a higher annuity rate, known as your `open market option'.
A new approach to annuities
There have been big changes in the world of annuities over the past decade. Much lower interest rates and increased life expectancy have led to a huge drop in annuity rates. Therefore, any factors which will help to improve annuity rates will be greatly welcomed by those approaching retirement.
One market trend is the increased tailoring of annuities in order to target particular groups of people, known as `individual pricing'. Of course, as with most financial-market changes, there will be winners and losers. For example, the introduction of `postcode annuities' by leading provider Norwich Union (NU) will mean lower annuities for some people and higher payouts for others.
Although the UK is one of the richest and most highly developed countries in the world, there are still extremes of life expectancy throughout our nation. By adjusting annuity rates to take into account the residential location of annuitants, payouts will improve in lowly areas. Likewise, annuity rates will fall for those living in affluent areas. Take a look at these figures:
City | Male life Expectancy (years) | Female life Expectancy (years) |
|---|---|---|
Kensington & Chelsea | 82.2 | 86.2 |
East Dorset | 80.9 | 84.1 |
Manchester | 72.5 | 78.3 |
Glasgow | 69.9 | 76.7 |
As you can see, a gent living in swish Kensington & Chelsea can expect to live 12.3 years longer than, say, a man living in the deprived Gorbals area of Glasgow. Of course, the main reason for this huge gap is lifestyle, with the wealthy enjoying lower stress, better nutrition and superior healthcare. Thus, annuity rates can be made more accurate by adjusting them regionally.
This explains why, from 22 September, Norwich Union will follow in the footsteps of Legal & General by introducing postcode-rated annuities. NU plans to divide the UK into nine categories, based on local life expectancy. This could see a difference of up to 2% on the income paid to two identical customers living in very different postcode categories. The insurer calculates that seven in ten annuitants (70%) will be in a similar or better position, with the remaining 30% being slightly worse off.
Of course, as annuities become increasingly personalised, payouts will increase to people with poor life expectancy but fall for the healthy and wealthy. I'm sure most of us will welcome the end of this cross-subsidy to the wealthiest parts of the UK. Indeed, it seems likely that other insurers will adopt similar methods in order to improve the accuracy of the `annuity gamble'.
Hence, it is now more important than ever to shop around for an annuity that pays the very highest rate to you as an individual. Amazingly, only two in five pensioners (40%) make use of their open-market option. Alas, the remainder will be losing out on thousands of pounds during the later years of their lives. Oops!
More: Get your free pension guides today | How To Save For Retirement | Good News About Your Pension