Jeff Salway: Hard to hedge on a pension annuity

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SCOTS holding out for a rise in the income they can get from their pension savings have been warned they are playing a dangerous game as annuity rates look set to fall again.

The rates on annuities, with which the vast majority of people convert their pension savings into a regular income at retirement, have plunged over the past four years. And while rates rose last month, hopes of a sustained increase appear to have been dashed by the Bank of England.

Longer life expectancy and regulatory pressures mean annuities are on a long-term downward spiral that has accelerated since quantitative easing (QE) launched in 2009.

By driving down gilt yields, which are used in the pricing of annuities, QE has wiped thousands of pounds off the retirement incomes of millions.

The income paid by annuities has plunged by almost 30 per cent since 2009, according to Axa Life Europe.

A rise in gilt yields sparked fresh hope of a resurgence in annuity rates last month. Several insurers increased their level and indexed-linked annuity offers, albeit not to the extent of the jump in gilt yields. Now, however, experts say the improvement is likely to be short-lived.

Their caution is informed by a Bank of England statement signalling its intention to keep interest rates down and suggesting that further QE is on the way, delivering a cruelly timed blow for those nearing retirement.

So what should you do if you’re retiring over the coming months, or have done recently but held off deciding what to do with your pension pot?

On the face of it there’s a simple choice: to buy, or not to buy. This will be informed by whether you think annuity rates will climb in the near future, but it’s a gamble.

Paul Gibson, chartered financial planner at Carbon Financial Partners, said: “Annuity rates have fallen almost continuously over the past 20 years and some have recently suggested it may make sense to defer purchasing one as annuity rates are anticipated to increase moving forward.”

But the wait-and-see approach is a “dangerous exercise”, according to Gibson.

“Even if rates improve, by how much and when is open to much debate. For example, if you can secure an annuity of £6,000 a year today but decide to wait a year and rates are 10 per cent higher, you would receive an annuity of £6,600. You have, however, foregone £6,000 of income and would need to live for at least ten years before you are better off.”

One option for those deferring annuity purchase is to take advantage of their ability to draw up to 25 per cent of their pension as tax-free cash (provided they haven’t already done so).

“But tax-free cash can’t be taken without also having to make a decision about what to do with the rest of the pension,” noted Paul Lothian, director at Verus Financial Planning in Dundee. “However, it is possible to have an income withdrawal plan paying zero income, allowing annuity purchase to be deferred.”

Buying an annuity on retirement will remain the default for most people, with the argument in favour of deferring not sufficiently compelling. But there are still decisions to be made that can have a big impact on retirement finances.

The first step is to ensure you get the best deal possible, given the difference of up to 20 per cent between the best and worst annuity rates on offer. Annuity rates can be compared at websites including like this.

Around nine in ten people buy level annuities, yet most financial advisers say inflation-linked annuities should be the first choice. While the income is lower at the outset, the protection against rising prices can become invaluable in the longer run.

Inflation averaging 3 per cent can slash the value of income from a level annuity by up to 53 per cent over a 25-year retirement, according to MGM Advantage.

Also find out if you qualify for an enhanced annuity, which pays a higher income to people with health conditions or lifestyle factors (such as smoking) that might impair life expectancy.

And remember that you don’t have to spend all your pension fund on one annuity.

“A more pragmatic approach often adopted is to purchase annuities in stages and provide a base level guaranteed income to meet essential expenditure and adopt a more adventurous approach with the balance,” said Gibson.