Boosting your pension

Most people in the UK now have some sort of pension fund. That can be the fund built up at work in a so-called ‘money purchase’ or ‘defined contribution’ pension – in other words one that is not linked to your salary. It can be a personal pension paid into when you are self-employed or an employee. It can be the additional voluntary contributions – AVCs – paid on top of a company pension. Or it can be money paid into a stakeholder scheme. Many people will have more than one of these funds.

Timing
At some point you have to ‘retire’ and convert each of your funds into an income for life. You can choose a different age for each fund if you want. ‘Retiring’ does not mean you have to stop work. It is just the term used when you stop paying into a pension fund and start taking the pension out. If you pay into a company scheme you normally have little choice about when to retire – the scheme will set the age. If you have a personal pension with one of the big insurance companies you will normally have picked a retirement date when you started the pension scheme. Some companies impose a penalty if you decide not to retire on the date you chose many years ago. If you do not face these restrictions then you can retire at any age between 50 and 75, though in 2010 that lower age will be raised to 55.

There are two advantages to converting your pension fund early. First, the money will have to be stretched over more years. At 60 a woman can expect to live 23 years – if she waits til 65 she can expect 19 years and at 70, 15 years. So the same pension fund will buy a bigger pension if she waits. Second, you – and perhaps your employer too – will be paying into your fund for longer. So it should be bigger in five or ten years than it is now.

However, there are two big disadvantages. All the evidence is that annuities – the pension for life you buy with your fund – are going to become more expensive over the next fifteen years(see Money News, this month, pxxx). So if you wait you will probably get less pension for the same fund. Second, although we all hope investment growth will boost savings over the next five or ten years, it may not. Many people are sitting on a pension fund now that is not worth as much as it was five or even ten years ago.

Annuities
Once you have taken the plunge, you must convert your fund into a pension. You normally do that by buying what is called an annuity. You give an insurance company your pension fund and it promises to give you an income for the rest of your life – a pension.

But even here there are important choices to make. For the same fund, you will get a much bigger pension from some insurance companies than others. The difference between the top and bottom of the best ten can be £1000 a year for life – a big price to pay for choosing the wrong company.

Nowadays everyone should have the choice to buy an annuity from any company in the market. However, the choice is not so freely available as it should be. Although you have the right to take your fund and buy your annuity anywhere, many companies refuse funds that are too small. A lot now set £10,000 as the lower limit. So if your fund is smaller than that you will have much less choice and may have to buy an annuity from the company you saved with – however poor value it is.

Choices
Once you have decided to buy a pension, there are other choices to make. The examples below assume a pension fund of £100,000 to buy the annuity. That is a lot bigger than most people in fact have. But it makes the arithmetic easy. If your fund is half that, £50,000, you would get roughly half the annuity. If it is a quarter of that –the average fund is about £25,000 – then divide all the amounts by four. And so on.

Inflation: The first choice to make is whether to buy pension which rises each year in line with inflation – or one which stays the same amount. Prices are rising by around 2.5 per cent a year. That is fairly low – but remember 1980 when inflation peaked at 21 per cent. That could happen again. And with retirement lasting 20 years or more, even a low rate of inflation can erode the value of your pension. An inflation-proofed pension is much less at first. A man of 65 with £100,000 to buy a pension will get a maximum of £5317 a year fully inflation-proofed. But he could get £7486 as a flat rate pension for life. If inflation stays around 2.5 per cent his inflation-proofed pension will be less than the flat-rate pension for the next 13 years and more each year after that.

Guarantee: An annuity is a gamble. You give the money to an insurance company and they give you a pension for life. If you live longer than average you win the bet. If you live an average time or less the insurance company wins. But it does seem a waste of money if you buy an annuity and then die within a few months. The insurance company will not return it to your heirs and it has won the bet in spades. So you can buy a guarantee to make sure the annuity pays out for at least five or ten years even if you die. Of course that costs you money. A man of 65 with £100,000 to buy an annuity will get about £35 a year less if he guarantees the payments for five years or £120 a year less to guarantee it for ten years. It will cost a woman less.

Protect your spouse: If you have a wife or husband who is dependent on you then you should make sure your annuity will be paid to them after your death until they also die. This is called an annuity on joint lives. You can choose to have the annuity continue in full or at half or two thirds the rate. A man of 65 with a fund of £100,000 will get around £1200 a year less if his annuity is on joint lives. But it can cost a woman nothing.

Disease: If you smoke then you should always look for a better deal. Smokers get higher annuities because they can expect to live less time. Other things being equal, being a smoker can add a few hundred pounds a year to the annuity you buy with £100,000. If you have a disease that is likely to shorten your life then you can get a greatly enhanced ‘impaired life’ annuity from a specialist provider.

Tracing pensions
Most people have more than one job and it is easy to lose track of old employers and the pension schemes you may have paid into. You can track down old pension schemes free through the Pension Schemes Registry, a government agency with details of around 200,000 schemes on its computer. The more information you can give about your old employer and when you worked there, the better the chance of tracking down your pension. If you are trying to find a personal pension the name of the insurance company it was with or the adviser who sold it you will help. Call 0191 225 6316 or fill the form in online at www.opra.gov.uk

If you cannot find your pension it is possible that your employer did not have one – or you may have chosen not to join it. And even if you did, you may have had your contributions refunded or transferred to a new scheme when you left the company.

Small and big
If a particular fund you have tracked down is less than £2500 then you can cash it in. The same is true of a company pension that is less than £260 a year. The first 25 per cent is tax-free and the rest is taxed at 35 per cent. From April 2006 these rules will change and funds totalling up to £15,000 can be cashed in with the balance taxed as income (see Saga Magazine May 2006).

If your fund is big and you are under 75 then you can choose what is called ‘drawdown’. You put off buying an annuity, invest the money, and draw some of it off as a pension. These schemes take annual charges out of your fund and are not recommended for anyone with a fund of less than £250,000. With annuity rates likely to fall, they are probably not a good idea for anyone.

June 2004

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