The most important financial decision you’ll ever make

by Jane Baker on 07 July 2010  |  2 comments
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Guest blogger Brian Morgan, director at Heath Lambert Consulting explains why choosing how to take benefits from your pension is never a decision to be taken lightly.

Guest blogger Brian Morgan, director at Heath Lambert Consulting explains why choosing how to take benefits from your pension is never a decision to be taken lightly.

There’s not a lot of point saving hard to build up a worthwhile pension pot only to make poor decisions when you come to retire.

Moving from earning a salary to taking a pension income heralds the single biggest investment decision you’ll ever make. It’s vital to research your options in order to secure the best benefits. And this is doubly important because the most popular option locks you in for life.

Defined benefit versus defined contribution

Retirees with final salary pensions - also known as defined benefit schemes - have a simpler job because the income available is linked to salary and years of service. The main decision will be whether to take tax-free cash now in return for giving up regular income. However tempting it is to grab the cash, do think about the long-term effects of a reduced income.

But an increasing number of people are retiring with defined contribution (DC) schemes - such as ordinary personal pension plans - which raise more complicated issues.

With a DC scheme you’ll know how much is being paid in but, unlike final salary schemes, there are no income guarantees once you retire. This will depend on the size of the pot at retirement and the returns available on the financial markets at the time. Currently these have reached to historic lows.

When you retire, your pension provider is likely to offer to pay you an income for the rest of your life in return for your pension pot using a lifetime annuity. This should be viewed as an opening skirmish and not a done deal.

You don't have to buy an annuity

You don’t have to buy an annuity. And you don’t have to buy the one your pension provider offers you. Instead, you have the right to use the ‘Open Market Option’ which means you can shop around for the best deal.

But why should you buy a lifetime annuity at all? Because the provider guarantees to pay you a regular income for the rest of your life, regardless of how long you live. That’s pretty important for people who will usually have few other revenue streams and could easily survive two or three more decades after retiring.

On the other hand, why shouldn’t you buy a lifetime annuity? Because while the alternatives make no absolute guarantees about the income you’ll get, they do allow you to make financial planning decisions not just at retirement, but throughout your retirement.

People’s circumstances do change as they age. Most obvious is declining health. Buy a lifetime annuity too early and you could be stuck with a lower ‘healthy lives’ rate that doesn’t reflect your true life expectancy. There are external threats too, such as rising inflation. More positively, many receive inheritances from their own parents or relatives in early retirement that transform their financial situation.

Alternative options usually have more generous death benefits than lifetime annuities to guard the value of the fund against premature death. They also allow the income to be varied at points through retirement, taking more in the active ‘primetime’ retirement years and subsidising the later years through inheritance or downsizing a property.

Some options allow you to take income but keep the funds invested to benefit from potential future growth in the underlying assets such as shares, bonds or property.

Fixed term annuities

Conversely, if you wanted the flexibility and better death benefits without investment performance risk or extra costs, consider a fixed-term annuity that keeps your options open. This pays a guaranteed income for an agreed term but then returns a maturity lump sum that allows you to buy a new plan, giving the choice of switching to a higher paying ‘enhanced annuity’ for those suffering fading health.

Retirees get lifetime annuities served up to them on a plate but that’s no excuse not to check the full menu. You have until age 75 to buy a lifetime annuity - an age limit now under review - so ask yourself what’s the hurry?