Panic is sweeping stock markets across the world, share prices and pension funds are in freefall, and we’re all becoming used to seeing doom-laden financial news reports. But what does all this economic chaos mean for your pension?
Stock market instability (coupled with low interest rates) has left workers who are nearing retirement with a raw deal. According to new figures from accountants PriceWaterhouseCoopers, overall pension incomes are 30% lower than they were just three years ago.
Most companies have now ended the older, more generous ‘final-salary’ pension schemes. Instead, they have switched to ones that are dependent on the performance of the stock market.
Unfortunately the stock market is taking a hammering right now. As a result, annuity rates are falling through the floor – which is bad news if you’re approaching retirement.
Why is it bad? What is an annuity?
An annuity converts your pension fund into a guaranteed income. You hand over your pension pot savings to an insurance company, and in exchange they pay you a regular fixed income for the rest of your life.
But with the economic climate being so rocky, annuity rates are pretty poor at present – and it’s these rates that determine how much pension income you receive in return for the money you have saved up during your lifetime.
You can only set your annuity once. Then it’s fixed for life – so it’s one of the most important financial decisions you can make.
“For many years, many people have commented that a guaranteed conventional annuity is the safest option available for people who are looking to secure an income from the pension pot,” says Ray Black, Independent Financial Adviser and Managing Director of Money Minder. “Nowadays, I’m not so sure this is true. The threat of inflation, amongst other factors, means that there’s a lot more risk to buying an annuity than in the past.”
There’s no way to sugar coat this – if you were planning to retire in the next couple of years, you’ve been dealt a bad hand. Pensioners retiring today will see a lower income – and the very real threat of future inflation rises means the situation could get even worse.
However there are different types of annuities (as well as complete alternatives to them). So what options do you have when securing a decent retirement income?
1. Put off retiring
Ok, so this isn’t a retirement option as such – but it is a very real alternative that shouldn’t be dismissed out of hand. There are a number of benefits:
- If you can continue working for a few more years, you might find that the market (and therefore the annuity rates on offer) improve
- You get tax benefits for working past State Pension age (such as not paying National Insurance)
- You get extra pension money from the government in return for working longer
- You will be directly boosting your retirement income through work itself
For full details on the tax benefits of deferring your pension, click here.
2. Purchasing a ‘normal’ annuity
This is what the majority of people do when looking to secure an income for their retirement.
With an annuity, you can only fix it once. You exchange the lump sum of money you’ve built up in return for a fixed income – but then you are locked into that rate of pay for your whole retirement.
So whenever you buy an annuity, the golden rule is to shop around. Rates can vary hugely from one provider to another, and it can make a big difference to your eventual retirement income.
However, as discussed above, now isn’t the best of times to be buying an annuity, as rates are so low.
“The thing is, unless you buy an annuity with inflation proofing, the buying power of the income is sure to reduce over time,” warns Ray Black. “For some, it will make much more sense to consider an investment linked annuity that at least has a chance of going up over time and may help to ward off the effects of rising prices over the longer term.”
3. Purchasing an investment linked annuity
Unlike conventional annuities, investment linked annuities don’t give you a fixed income – they are designed so that they provide you with an income that (hopefully) increases during your retirement.
As you will have guessed from the name, investment linked annuities are linked to an investment – and as with any investment, it does contain an element of risk.
However, even the traditional ‘safe’ option of a normal annuity contains an element of risk – because if you fix your annuity now (while rates are so low) you run the very real danger of your pension income being eaten away by future inflation rises, amongst other things.
4. Withdraw your pension fund (‘Income Drawdown’)
Income drawdown is different from an annuity. Instead of handing over your pension pot to an insurance company for a guaranteed income, you keep control of the money you’ve saved – and decide where to invest it yourself.
This is a riskier option than annuities (your income is not secure) and it’s only really a realistic prospect if you’re well-off – you will need to demonstrate that you have a secure pension income of at least £20,000 a year (not including investment income). It’s a realistic option for those with pension funds of 100k or more (to put that into perspective – the average pension pot is estimated to be around the 30-40k mark).
However if you’re lucky enough to have that level of savings and you can afford to take on a bit more risk, it can certainly be worth considering.
5. Phase your retirement
This is where instead of converting your entire pension fund into an annuity or an income drawdown plan in one go, you set up a number of annuities or drawdown arrangements by gradually drawing on your pension fund.
Such an arrangement means you can gradually convert parts of your pension fund into income while leaving the rest of it still invested (where, depending on future annuity rates, it may fetch you a higher income in later years).
A phased retirement plan also allows you to control the level of income you receive by choosing the number and timing of each annuity you purchase. This gives you the luxury of planning around your own financial circumstances (and the current state of the annuities market).
It’s also good for tax-planning purposes. Because the money you take from a phased retirement is made up of two elements (a sum of tax free cash and an annuity) you can use the sum of tax free cash as your main source of income. This will reduce your exposure to income tax.
Finally, a phased retirement option can also be good for keeping death benefits high: because if, upon your death, you still have an element of your pension fund that has not been converted into annuity payments, some of it may be payable to your beneficiaries (free from Inheritance Tax).
Don’t forget the golden rule if you are purchasing an annuity: shop around for the best deal before you fix.
Also bear in mind that your financial circumstances are unique – the right retirement solution for you will depend on your personal circumstances. We therefore recommend you talk through your options with an independent adviser (you can find an independent financial adviser here).
After all, how to provide for your retirement is one of the most important decisions you’ll make – so you want to be sure you’ve got a pension plan that’s right for you.
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