It is the biggest decision of the rest of your life. You have saved up in a pension fund through a personal pension, a company ‘money purchase’ scheme, or additional voluntary contributions (AVCs) at work. At some point you will have to convert that fund into an income to pay for your retirement. Most people just ask the company they have saved up with to provide the income too. That is usually a big mistake. It can cost you hundreds – sometimes thousands – of pounds every year.

If you belong to a company pension scheme which promises to pay you a pension related to your pay then you do not have to worry about providing the income. But you may have a separate personal pension or AVC fund and you will have to turn that into an income at some point.

When?
The youngest age you can turn your pension fund into an income is normally 50. That rises to 55 in April 2010 and in some schemes you may find the rules stop you doing it before 60 or even 65. In any case it is generally best to wait because the younger you buy your income the lower it will be. You do not have to stop work or retire. You can choose when to take what the Revenue now calls a ‘benefit crystallisation event’ any time up to age 75. But once you reach that age you will have to turn your pension fund into an income.

Small
If the total of all your pension funds is £16,000 or less (£15,000 before 6 April 2007) it is called ‘trivial’ and you can take the whole lot as cash as long as you are aged at least 60. You have to count and cash in all your pension funds. If you also have a pension related to your salary then you must count the value of that as well. You do that by multiplying the pension you are due by 20. So a pension of £500 a year is ‘worth’ £500 x 20 = £10,000. Although the law will let you cash them in, not all pension providers will agree to it. If they do, then a quarter of the amount will be free of income tax. The balance will be added to your annual income and taxed as if it was income in that year. The way that is done may mean you are charged too much in the month you receive it and have to reclaim tax back at the end of the tax year. If you have more than one fund you may be able to reduce the tax by cashing them in over two tax years as long as you cash them all in within twelve months.

How much?
If your total pension funds are more than £16,000 (£15,000 up to 5 April) you can take a quarter as a tax-free cash payment. You have to use the balance to provide yourself with an income. Normally that means buying what is called an ‘annuity’. You give your pension fund to an insurance company and it guarantees to pay you an income for life. So it is a gamble. If you live longer than average you win. If you die younger than average the insurance company wins because it keeps whatever is left in your fund. Buying an annuity is a once-for-ever decision so it is important to get it right. Before you consider an annuity there are three things you will have to decide.

Flat or rising: your annuity can be fixed for life. Or it can rise each year with inflation. That will cut the amount you get at the start by about a third if you are 65. Fixing the rise at 3% a year is a bit less costly, cutting the initial payment by about a quarter. Not recommended – you will have to live a very long time to be better off.

Single or joint: If you have a spouse or partner who is financially dependent on you then you may want to ensure they will inherit part of your pension. A pension for them of two-thirds of yours will reduce the amount you get by around 10% for a man aged 65. Recommended if you have a dependant partner.

Gamble or guarantee: For a negligible reduction in your pension you can guarantee the payments will be made to your heirs for at least five years even if you die in that time. Recommended if you have heirs.

Some companies will offer you a non-guaranteed annuity linked to the stock market or other investments. They are not a good idea. You should also consider if you have any health problems. Most of us understate bad health when we talk to an insurance company. But when you buy an annuity you should be completely honest about any health problems, worries, or tests that you have had. The less healthy you appear the more you will get. Serious health issues can double the annuity you are paid. Even being a confirmed smoker can add about 15% to your annuity, reflecting your shorter life expectancy.

Once you have decided these things ask the company you have saved up your pension with how much pension it will give you for your pension fund. Some older plans may come with a guaranteed annuity which will usually be much better than you could get elsewhere. But most funds do not come with a guarantee and you are better off using what is called the open market option. You do that by finding out what other annuity providers will pay you and taking your fund to the best. You can see roughly what you would get using the comparative tables published by the Financial Services Authority or the simpler but slightly less comprehensive commercial website at www.annuitydirect.co.uk. Before buying an annuity it is best to talk to a specialist independent financial adviser, particularly if you have any health issues. A good independent adviser will find the best annuity for your particular circumstances.

However much you have in your pension fund, the chances are you will find the annuity you are offered disappointing. Longer life and lower investment returns mean a man aged 65 can reckon on getting only about £7000 for each £100,000 in the fund – and most people have a lot less than £100,000. Women get less because they live longer, about £6500 for each £100,000 they have saved up. At 60 you will get about 10% less; at 70 about 15% more. All those figures are the best on the market – the worst can be 10% less. So finding the best is vital to maximise your retirement income.

No thanks!
If you do not want to commit to an annuity you can just draw income from your fund. It is called an ‘unsecured pension’ and the maximum amount is fixed by law according to a complex formula. First you take a particular figure (technically the gross redemption yield on 15 year UK gilts) published in the Financial Times on the 16^th of every month. Then you use that to look up a value in a set of tables published by the Government Actuary. That produces what is called a ‘basis income’ for a man or a woman at a particular age which is roughly equal to the basic annuity they would get. The unsecured pension you can take from your fund is 1.2 times that figure. At the end of 2006 it came to £8640 a year for a man of 65 and £8040 for a woman of the same age.

Once determined this income remains fixed for five years. These amounts are the maximums – you can take less or even nothing if you prefer. If you die the balance in your pension fund – less 35% tax – can form part of your estate and be left to your heirs.

Once you reach 75 the rules change - and the Government is changing them again from April. You will still be free not to take an annuity. But the income you draw from your fund is called an 'alternatively secured pension'. From April this can be up to 90% of the 'basis income' at 75. On today's figures that would mean a man who had £100,000 left in their fund at 75 - and remember most people have far less - could draw an annual income of £9000. For a woman the figure is £8010. On death, any remaining funds can be left to a dependant's pension or to charity but if you leave them to anyone else they will be taxed at 70%.

There is a danger that if you take the maximum unsecured pension up to 75 and then the maximum alternatively secured pension after that the money in your pension fund will run out before you die.

www.fsa.gov.uk/tables

www.annuitydirect.co.uk

www.hmrc.gov.uk/pensionschemes/gad-tables.htm