How to beat low annuity rates

by Saran Allott-Davey on 10 September 2010  |  9 comments
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Guest blogger Saran Allott-Davey at Heron House Financial Management asks whether unsecured pension is a good alternative to annuities.

Guest blogger Saran Allott-Davey at Heron House Financial Management asks whether unsecured pension is a good alternative to annuities.

Record low annuity rates are making life tough for hundreds of thousands of retirees trying to secure a decent retirement income.

Falling annuity rates mean you need more pounds of pension fund to buy each pound of pension income. Last year annuity rates fell by 6 per cent but this continued a trend that has seen them fall by half since the early 1990s.

Retirees may think annuity rates have fallen to unattractive levels, but what choice do they have?

The USP alternative

One alternative is income drawdown or Unsecured Pension (USP), a way of taking income directly from the pension pot. This allows the bulk of the fund to remain invested giving potential – but usually no guarantee – of growth and also more flexibility to vary the payments while delaying annuity purchase.

The extra risks and costs mean income drawdown is often only seen as suitable for those with funds of £100,000 or more. But such generalisations can be unhelpful in financial planning and individual cases need to be taken on merit.

USP lets retirees take income they need but to buy an annuity at a time that suits them, rather than being forced into it at the point of retirement. You don’t need to be wealthy or have special financial expertise to question if locking up your entire pension fund in a lifetime annuity at a time of record low rates is wise, particularly while fund values remain depressed.

Decisions need to be based on the overall position of the retiree and their partner. Many couples have more than one pension fund, often with a ‘core’ of final salary income that is guaranteed and will rise with inflation, leaving several smaller funds that could pay a USP income while giving time for economic recovery. It also gives more time to decide whether to buy inflation-proofing or spouse’s pension which come with no guarantee the extra costs will be justified.

Running costs are no longer a barrier to even quite small pension pots moving into USP – many personal pensions allow drawdown and there is a wide choice of low-cost SIPPs available.

The risks

The primary risk to address is from taking a higher income than the fund growth can sustain, depleting the fund over time. Investments can be chosen to be as risk-free or adventurous as the individual wishes, but the fund value will still require monitoring. For ‘hands-off’ investors there are USP plans such as fixed-term or variable annuities which provide secure income and growth potential while retaining flexibility although these may mean extra costs.

USP is often dismissed as ‘just too risky’ but this needs to be set against the risk of spending your entire pension fund on a lifetime annuity when rates are at historic lows and inflation is creeping higher. The difference is that once purchased, you are locked into the fixed benefits of the annuity for the rest of your life.

Providing you are taking a sensible level of USP income then you will have built in some degree of inflation protection and usually the whole pot would be available to your spouse in the event of death.

Ideally I like to see people gradually move from USP to annuities over a period of years, if the pot is large enough. Annuities do make sense particularly later in retirement when the rates reflect reduced life expectancy and there is a real need to insure against outliving your assets.

In later life you will probably have a better idea about the need to include inflation proofing and spouses pensions too.  Until that point, USP combined with annuities can give guaranteed income, flexibility and scope for growth.