This pension mistake could destroy your finances

Find out why fixing your pension income now for the rest of your life could cause huge damage to your finances in retirement.

An annuity is a relatively simple financial product. When you buy one, it converts the pension fund you have amassed during your working life into an income. If you choose a level lifetime annuity - which most people do - you’ll end up with the same guaranteed, risk-free income for the rest of your life.

This type of annuity is popular because it provides you with peace of mind, as you have a secure income until the end of your days. But the trouble is, it is also highly inflexible, and will not respond to your changing financial needs if you are forced to increase your annual expenditure. 

One way around this is to choose an index-linked annuity or one which provides an escalating income. This will protect you from inflation and rising expenditure, but you'll need to accept a significantly lower income intially in return.

Research from insurer LV= reveals that, in the first few years following your retirement, your financial situation often changes dramatically and unexpectedly, which means locking into a lifetime annuity too early could leave you with insuffiient income to cover extra spending later on.

The table below shows the key events which often take place in people’s lives during the first five years of retirement which are likely to affect your income needs:

Key events which occur in the first 5 years of retirement

Source: LV=

These events may increase or reduce the amount of income you actually need to draw from your pension. But how can you plan financially for these occurences when an annuity ties you into a fixed income for ever more?

Fixed term annuities

One option is to choose a fixed term annuity, instead of a traditional lifetime annuity. This relatively new product enables you to fix your income but over a much shorter period of time, rather than for the rest of your life.

At the end of the pre-agreed term, not only will you receive a guaranteed maturity value back, but you’ll also have more options at this stage. For example, you could commit to a lifetime annuity if you’re ready to take a fixed income for life. Alternatively, you could choose another fixed term annuity to give you more flexibility.

Fixed term annuities are only available from two providers: LV= and Living Time, but other companies are expected to join the market soon. I’ll use the LV= product - known as the Protected Retirement Plan - as an example to explain how fixed term annuities work in practice.

You can select any term between three and twenty years, as long as the plan comes to an end by your 75th birthday and the level of income you want to draw is subject to GAD (Government Actuary’s Department) limits.*

You can choose whether the income is fixed or increases by a set annual percentage, up to a maximum of 8.5%. By choosing an increasing income, you will eat into more of your pension fund - but you will be able to combat the effects of inflation on your purchasing power.

At the end of the term

At the end of the agreed term of the annuity, you will still have a portion of your original pension fund left (assuming you are still alive at this point). This portion is known as 'the maturity value' of the fund. 

Like the income you'll draw every year, the maturity value is set at a guaranteed level at the beginning of the annuity term. So when you take out the plan, you’ll know exactly how much income you'll receive every year and you'll also know exactly how much money you'll have left at the end of the agreed term of the annuity.

Neither the income nor the maturity value can be changed at any time, and the plan can’t be cashed in either.

What affects the maturity value?

Several factors can have an impact on the maturity value, including:

• the size of your pension pot at the outset,
• the chosen term,
• your age and gender,
• the size of the income you have selected to take,
• whether you chose to receive an increasing income,
• any death benefits included in the plan (more details on this below), and
• the state of the investment markets when you purchase the plan.

Death benefits

If you die before the end of the fixed term, there are several death benefit options including:

• A dependant’s income - this ensures income is paid to your spouse, civil partner or dependant until the end of the fixed term,
• Value protection - this allows 100% of the original capital used to purchase the plan, less any income paid, to be returned as a lump sum (minus a tax charge of 35%) This would normally be paid to your estate although a beneficiary can be elected,
• A guarantee period - this guarantees that the income from your plan will continue be paid for a set period, regardless of when you die. The remaining income will be paid as a lump sum, less 35% tax.

Enhanced or impaired life annuities

A fixed term annuity would be particularly beneficial if your health deteriorates within the term, and then you choose to take out a special enhanced or impaired lifetime annuity once the plan has matured. These annuity products are specifically designed for people in poor health. As the table above shows, this is reasonably common since almost one-quarter (24%) of respondents said their health had worsened during the first five years of retirement.

Lifetime annuity rates are more generous for those who have suffered a medical condition compared with standard rates for a healthy person. This is because annuity rates are largely influenced by life expectancy. If your life expectancy is deemed to be lower than average, your annuity income will be higher to compensate for the fact that it is likely to pay out for a shorter period.

In this case, at the end of the fixed term annuity, you should consider applying for an Enhanced Annuity which takes your declining health into consideration, and provides a higher annuity income as a result. (It may also provide a better income if you smoke or are overweight).

If your life expectancy is significantly lower as a result of poor health, an Impaired Life annuity may provide an even larger income.

The downside of fixed term annuities

The chances are you’ll eventually buy a lifetime annuity in the end even if you have delayed it for several years using a fixed term annuity. But there’s a risk that by the time you come to do that, lifetime annuity rates could be much lower than they are now. After all, annuity rates are influenced by certain market conditions including interest rates and gilt yields (among other factors).

If conditions aren’t favourable in the future, your decision to delay could actually mean your remaining fund won’t stretch as far as it would have done had you bought a lifetime annuity as soon as you retired.  

So, most importantly of all, before you take any decisions, I recommend you consult a good independent financial adviser first.

*GAD limits are in place to prevent you from eroding the value of your fund by drawing a higher level of income than it can support.

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