FOR thousands of Scots retiring in the coming months, how they use their pension pot will be one of the biggest financial decisions they ever make. The vast majority will use their hard-earned money to buy an annuity – but now, more than ever, this decision requires careful consideration.
Several factors, including volatile markets and plummeting annuity rates, have combined to make the purchase of an annuity, which provides a guaranteed income for the remainder of their lives, less straightforward than ever for retirees. There remains a huge chasm in the annuity market between the best and worst providers, with millions losing out by sticking with pension providers that fail to offer them a decent rate of income.
With many people now retired for 20 years or more, there's a lot of time in which to count the cost of taking the wrong option, but those nearing retirement can take a few simple steps to get the best out of their annuity purchase.
1 SHOP AROUND
According to the most recent figures published by the Association of British Insurers, 63 per cent of retirees last year bought an annuity from their existing pension provider without looking for a better deal. Investors with the more competitive annuity providers – including Aegon, Legal & General and Aviva – are often better off staying where they are, but others are paying the price either for their loyalty or their apathy.
It's estimated that someone sticking with an insurer offering one of the least competitive deals could be getting 30 per cent less income from their annuity than if they used the Open Market Option (OMO) to shop around for the best price.
But four in five retirees have never heard of the OMO, according to annuity provider Just Retirement, which estimated that those retirees were missing out on around 500 million of extra income by missing out on the chance to seek a better deal.
Paul Lothian, director of Verus Chartered Financial Planners in Dundee, said: "Arguably, the insurance industry is not doing enough to highlight this option to pension savers when providing details of available benefits to the member at retirement.
"While the OMO is always included, it is clearly not being given sufficient prominence, often being hidden away on the last page of documentation."
Use the internet to search for the best annuity, with helpful websites including www. moneymadeclear.fsa.gov.uk and www.annuity-bureau.co.uk.
2 ENHANCE YOUR PROSPECTS
This country's poor health record means that many Scots could benefit from taking an enhanced or impaired annuity.
These are available to smokers and those with health conditions that could reduce their life expectancy and they pay out a higher income on the assumption of a shorter payout period.
An enhanced annuity could pay an income of up to 50 per cent higher than might be paid by the existing pension provider, which will generally not take account of your health, said Lothian.
"Given the increasing numbers of impoverished pensioners, it's concerning that more people don't seek to maximise their pension income in this fashion."
As Nigel Callaghan, pensions analyst at Hargreaves Lansdown, explained, annuity purchase is the time to come clean about any health conditions you may have. "People are conditioned to downplay things, but this is the one time to tell your insurer if you smoke, or if you have one of the 1,500 medical conditions that could entitle you to an enhanced annuity, such as high cholesterol, high blood pressure or being overweight."
3 MIX AND MATCH
Recent years have seen investors take a more sophisticated approach to buying annuities.
With annuity rates on the slide for the past year and pension fund values hit hard by market turbulence, many retirees have sought to phase their annuity purchase in the hope that rates will improve and their funds will recover, said Callaghan.
For example, someone buying an annuity with a 100,000 pension fund might break it down into three portions.
They may then use a third of it to buy a level annuity so that they can get the maximum annuity income from day one; another third could be used to buy a 100 per cent spouses pension; and the final third used to buy a retail prices index (RPI) linked annuity, to hedge inflation.
"You can buy different annuities with different bits of your pension to hedge against inflation and annuity rate movements," said Callaghan.
"When deleveraging has fully unwound, inflation is likely to soar."
4 INFLATION PROTECTION
Buying an RPI-linked annuity is just one way to reduce the risk posed by inflation to your retirement income.
A fixed escalating annuity, where the income paid out increases by a certain amount a year – usually 3 or 5 per cent – can provide a useful halfway house between a level and RPI-linked annuity, Callaghan advised.
"Escalating annuities are good value for money. RPI-linked annuities provide total protection against inflation but they are very expensive and the starting income is typically 30 per cent less."
He recommended fixing the annual increase at 3 per cent, pointing out that inflation below that level is rare.
Poor health a good reason for settling on a level deal
AS A diabetic who is no longer able to work, Leonora Simpson, of Glasgow, has good reasons to make the best of her annuity. Leonora had built up contributions to a state second pension (then known as Serps, now as S2P), but the benefits cannot be drawn until the state pension age is reached. For women, that gradually increases to 65 between 2010 and 2020, so Leonora, now 55, will be 63 before she can take hers.
But she decided that, with surgery due in the near future, she would be better off taking the 25 per cent tax-free lump sum to which she was entitled from the pension, rather than leave it untouched until she can draw the whole amount.
She used the money to buy a level annuity from her pension provider, Standard Life. "I was aware that you can shop around and looked at other prices on the market, but there wasn't much in it because the rate offered by Standard Life was very good."
On learning of her diabetes, the insurer also told her she would be eligible for an enhanced annuity.
"Because of my health they said I could get a higher rate, but in the event it would only have been 1.20 a month difference," Leonora explained. "I was disappointed it wasn't more and decided to settle for a normal annuity rather than wait any longer." The initial sum was paid quickly and she used it to pay off credit cards.
She also plans to take a holiday before she needs any serious surgery. "Why struggle when you can use money that is yours?" she reasons. "I am unable to work because of my health, and you never know what's in front of you."