The Pensions Trap

You have saved for decades for your retirement. Your pension pot is filling up – there is probably more money in it than you have ever owned at one time in your life. Then when you decide to retire, you find that the Government tells you how to invest it. And the returns you can get are a fraction of what you hoped. That is the pension trap. And tens of thousands of people fall into it every year.

The people affected are those who have paid into a pension scheme which makes no guarantees about the level of pension they will get. A growing number of company pension schemes are like that (see box). So are all personal pensions, and the additional voluntary contributions (AVCs) which many people make on top of their company scheme.

The traditional way to use your pension savings to produce an income is to buy an annuity. They work like this. You give an insurance company all the money you have saved and in exchange it gives you a guaranteed income for life and when you die, your income stops and it keeps whatever is left. There are variations on this basic model, but that is the essence of it. The money you are paid is partly the return of your capital and partly the interest the balance is earning. The insurance company takes a gamble on how long you will live – if you live less than average it makes money; if you live much longer than average then it ends up paying you more than the value of your investment. To get its sums right, the insurance company not only has to estimate how long people live on average, but it also has to estimate how much your fund will earn over that period. Recently, life expectancy has grown, and the rate of return on investments has fallen. The result is that annuity rates have halved over the last ten years.

Today, a man aged 65 with £100,000 in his pension fund who buys an annuity today will get a maximum annual income of £9000 a year guaranteed for his life – which on average will be just under 19 years. A woman will get rather less – the current top rate is around £8300, simply because her life expectancy is longer at well over 20 years. Someone retiring with the same fund ten years ago would have got nearly double those amounts, guaranteed for life. These amounts are before tax and all the income from a retirement annuity is taxable. Even though some of it is a return of your capital, you were allowed to save it up out of untaxed income. So the government taxes it now. How much tax you pay on it will depend on your age and other income.

A couple of years ago, the Government took a small step towards helping people who do not want to buy an annuity at once when they retire. Under these rules you can wait until you are 75 before you convert your fund into an annuity. Instead, you put it into what is called an ‘income drawdown’ plan. You can take income out of it, but the maximum amount is fixed by law at around the amount you would get from a good annuity scheme. The minimum you can take out is 35% of that. In addition to the money you take out of the fund, the financial institution which manages it will make an initial charge of up to 5% of your fund and an annual charge which could be as high as 1%.

So by the time you finally take the plunge into the cold bath of an annuity, the income you get for your much reduced capital may well be less than you would have got if you have bought an annuity at 65. There is no sign that annuity rates will be any higher in future than they are now.

Income drawdown is not recommended if you have less than £250,000. On the other hand if you have more than that and you invest it wisely, it can be a good idea. It puts you in control of your own money and if you die before you are 75, the balance can be inherited. But at 75 it has to be used to buy an annuity.

There is growing pressure on the Government to give people more freedom about how the convert their pension fund into an income. The new Labour Government has no plans to make any changes.

When you do buy an annuity, the decisions you make will affect your income for the rest of your life. The first and most important choice is the financial institution you buy it from. The company which has looked after your pension fund will usually not give you the highest annuity. You can choose to move your money to a better one. This choice is called the open market option – but most pension companies do not tell you about it and most people do not make use of it. They leave the money where it is, costing them thousands of pounds over the rest of their life. For example, the difference between the best provider and the tenth best provider – the top and bottom of the top ten – for a man aged 65 can be more than £750 a year – so by choosing the wrong one he would lose a total of £15,000 over a 20 year retirement. So picking the best is vital. But before you do that, you have to decide what sort of annuity you want. There are three main choices to make.

First, do you want your income to be fixed over your life, or do you want it to rise with inflation? This is a crucial decision. Over the last 20 years inflation has slashed the value of money by more than half. If you had £1000 in 1981, you would need £2366 to have the same spending power today. Over that period prices have risen by 4.35% a year. It is a lot lower than that now. But even if it stays around the government target of 2.5% a year, your money will halve in value over 28 years – a period of retirement that many of us can look forward to.

So inflation protection is a good idea, though an inflation proofed annuity is a lot less initially. A flat annuity bought for £100,000 by a man of 65 can be as high as £9000 a year. But inflation will eat away at its value each year. The best inflation-linked annuity is just under £6700 a year. But each year that will be increased by the rate of inflation. So it will be worth the same however long you live.

Another choice which is getting more popular is to go for a ‘with profits’ or ‘unit-linked’ annuity. These are investments linked to the stock-market and the amount you get is not guaranteed. But it can be a cheaper way to protect your income against inflation. On the other hand, you run the risk of your income falling if the fund it is invested in performs badly.

If you are married you have to decide if you want your wife or husband to continue to get part of your annuity when you die. If you do not do this, then on your death the income will stop. But you can choose instead that your surviving spouse will get a proportion, normally a half or two-thirds, of your annuity if you die. Of course, if your partner has his or her own pension, you may not feel this is important. But if you do choose it, the annuity you get will be reduced. The amount will vary depending on your relative ages.

You may also want to give some protection to your heirs or spouse by another route. With a pure annuity, if you buy it on Monday and die on Tuesday you have had nothing and the insurance company would keep the lot. So many people choose a guarantee period – usually two or five years – which means the income will be paid for at least that long even if you die within that time. Needless to say, this option also costs money, the amount will vary from provider to provider.

Finally, if you are a smoker or have a known health problem then you should get a better annuity rate because your life expectancy is shorter. The rates and the conditions applied to these so-called ‘impaired life’ annuities vary enormously and you should go to a specialist provider to find the one that is best for you.

The Annuity Bureau ltd 020 7902 2300

Annuity Direct 020 7684 5000 

· Final salary schemes – guarantee the pension you get as a certain percentage of your salary in the last years of employment. Typically you would get 1.25% of your final year’s salary for each year in the scheme. They are mainly found in the public service or some bigger companies. In some schemes the pension is increased each year in line with the rise in prices. They can also be called ‘defined benefit’ schemes because it is the amount of the pension which is guaranteed, not the contributions you pay.

· Money purchase schemes – store up all the contributions made into your pension throughout your life into your own pension ‘pot’. When you retire you have to use that money saved and the interest it has earned to buy a pension for yourself. The amount you get will depend on long-term interest rates and your age at the time you retire. They can also be called ‘defined contribution’ schemes because it is the amount you pay in which is fixed, not the pension you get at the end.

August 2001

e-mail Paul Lewis on paul@paullewis.co.uk