Why it's vital to protect your pension income

If you buy a standard annuity with no bells and whistles it'll only last as long as you do. But here's a very cheap way to protect it.

When you retire the chances are you'll turn your pension pot into an income using an annuity. Your annuity will then keep on paying out until the end of your days.

Sounds fair enough. 

But imagine this: you save up really hard during your working life and you build up a decent pension fund worth £200,000. You buy an annuity which pays you an annual income of £13,000. But, sadly, you pass away just two years after retiring.

This means you would have received a total payout from your annuity of £26,000. But it also means that your annuity company will keep the rest of your original pension pot - that is, the remaining £174,000.

Still seem fair?

How can you protect your annuity?

So, how can you stop all the saving you've been doing from going to waste? Well, luckily there's a way you can protect at least some of your annuity.

It's called an annuity guarantee, and it ensures your annuity keeps on paying out for a fixed minimum period whether you survive that long or not. Guarantees can be added which last for either five or 10 years.

Even better, guarantees are cheap too. The table below shows the difference in the amount of income you would receive from your annuity depending on whether you have asked for a guarantee or not.

The figures are based on an example pension pot of £10,000 and show the income you would get each year:

Annuity rates

Source: Investment, Life & Pensions Moneyfacts. August 2009. The rates shown are for a standard level annuity which pays the same income every year.

In the first column - annual income at age 65 without a guarantee - you'll see that a £10,000 pension pot would pay you an income of between £571 and £689 a year with no guarantee. An annuity bought on this basis will only pay out as long as you survive whether that's three years or 30 years. But the income automatically stops on death whenever that happens.

Five year guarantees

However, in the second column - annual income at age 65 with a 5 year guarantee - your annuity is guaranteed to pay out for at least five years. You'll see the income you get has been reduced slightly to cover the cost of the five year guarantee. But notice how minimal the difference between the two is.

For example, the market-leading annuity from Canada Life will pay £689 a year with no guarantee, but this is only cut down to £686 a year with a five-year guarantee. It's a similar story at the other annuity companies too. (And for people who are younger or older than 65).

Remember, with this protection, your annuity will pay out an income for at least five years. So, if you only survive for one year after starting the annuity, it will continue to pay an income for the next four years. This could be a highly valuable benefit to the family you leave behind. What's more, in this example, it has only cost you a tiny £3 a year in terms of the income you'll have to sacrifice.

If you have a larger pension pot, multiplying the cost up will give you an indication of how much income you'll need to give up. If your pension was worth £200,000 rather than £10,000, the guarantee would cost around £60 a year.

(Note that annuity companies sometimes apply different annuity rates to different sized pension pots. So multiplying the figure up isn't always 100% accurate, but it does give you a good estimate).

Ten year guarantees

In the third column - annual income at age 65 with a 10 year guarantee - your income will be reduced a little further again to cover the cost of guaranteeing annuity payments for ten years. Using Canada Life as an example again, your income would be cut by £14 a year from £689 for an annuity with no guarantee to £675 with a 10 year guarantee.

And the difference between annuity payments with a five year guarantee and a 10 year guarantee is just £11 a year.

So, what effect would a 10 year guarantee have on our original £200,000 example? Well, you survive for two years after buying the annuity and receive a total payout of £26,000 (2 x £13,000). But it's guaranteed to continue for another eight years. This means the annuity will provide another £104,000 (8 x £13,000) before it stops.

It's true the remaining £70,000 of your pension pot will be retained by your annuity company. (You and then your estate/dependants will have received a grand total of £130,000.) But that's still a hell of a lot better than the £174,000 you would lose without a guarantee at all.

How do you buy a guarantee?

When the time comes to buy an annuity, if you're smart, you'll shop around for the best rate. All you need to do is make sure you specify you want a guarantee when you ask for a quote. If I were you, I'd definitely go for the maximum ten years to make the most of the protection on offer. It's as easy as that.

I think the cost of a guarantee is a really, really small price to pay to make sure your annuity pays out for an entire decade. In fact, buying a guarantee is a great way to keep as much of your pension pot as you can out of the hands of your annuity company if you don't survive for long after retiring.

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