This piece first appeared in Saga Magazine in February 2002
The text here may not be identical to the published text

For Richer Or Poorer


Converting your pension fund into an annuity

Are you one of the millions of people who has taken the advice to pay money into a pension scheme? If so, do you know how that money is converted to a pension when you retire? Few people do – most of us have better things to do than worry about the mechanics of their pension. But as you approach that life-changing day when paid employment becomes a memory, it is vital to understand what your choices are. Otherwise you could end up poorer for the rest of your life.

Many people in a company pension scheme will get a pension related to their final salary. They are the lucky ones. Their pensions are guaranteed by their employers – as long as they stay in business. But more and more of us have money in a different kind of pension. They go by two names - ‘money purchase’ or ‘defined contribution’ schemes. Many of these are company schemes but they also include all personal pensions, stakeholder pensions, and the AVCs (additional voluntary contributions) paid to top up a company scheme. If you have one of these schemes you are restricted by law in what you can do with the pension fund you have saved up. You can normally take a quarter of your money as a tax-free lump-sum and do what you like with it. But what you do with the rest is strictly controlled. Eventually, you will have to use the balance of your pension fund to buy an annuity.

What is an annuity?

You give an insurance company your fund, and it promises to pay you a pension for the rest of your life. That is called an annuity. The insurance company uses its knowledge of life expectancy and investments to work out how much it can give you year by year and still make a profit at the end.

When do I have to buy an annuity?

Once you reach 75 you have to use your pension fund to buy an annuity. Before that age you can choose to keep your fund and take some income our of it. That is called ‘income draw-down’ but the amount you can take is limited and the company selling you the draw-down scheme will charge fees. For people with less than around £250,000 in their fund, draw-down is not a good idea. You may as well buy an annuity.

So what choices do I have?

The most important choice is the freedom to go to any insurance company to buy your annuity. It is called your ‘open market option’. And using that choice can mean a much higher income every year for the rest of your life. The difference can be startling. Even among the top ten providers the difference between the best and the worst income can easily be £1000 a year.. The company that runs your pension fund is usually NOT the best company to buy your annuity from. So get advice and choose the best.

What other choices do I have?

You must also choose whether to take a fixed income which stays the same every year, or whether you want your income increased each year in line with inflation. Although inflation is low now, over the last 20 years prices have risen on average by 4.1% a year. If you had an annual income of £10,000 20 years ago, you would need £23,000 a year to be as well off now. Most people do not choose an annuity that rises with inflation because it starts a lot lower. For example, a man aged 65 with £100,000 pension fund could buy an annuity of around £8500 from the best provider. But if he wanted an income that rose each year with inflation, he could only get £6500. Of course, the £8500 would never change. The £6500 would go up each year in line with inflation. But it is a tough choice when you have just retired and need more money.

What’s the problem with annuities?

Over the last few years, the amount of annual income you can get from an annuity has been cut almost in half. First, we are all living longer – a retirement of more than 20 years is now common. So the insurance company has to divide your money over more years. Second, interest rates have fallen dramatically so the money in your fund earns less. The result is that many people who have taken Government advice and saved hard for a pension now find the income they get is much less than they expected.

Many people think that we should be free to do what we like with the money we have saved for our retirement. The Government is concerned that left to our own devices we could spend it all or lose it in bad investments and then ask for help from the state, even though we have already had a huge subsidy in tax relief on our pension contributions. It is consulting at the moment on plans to change annuity rules – but it is unlikely it will do anything dramatic.

February 2002


go back to Saga writing

go back to writing archive


go back to the Paul Lewis front page

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


All material on these pages is © Paul Lewis 2002