You are making this pension mistake

Most of you are making this mistake before you cash in your pension pot for an annuity - avoid it, and you could save thousands of pounds!

Whenever I think about my pension - what little there is of it - I always tend to focus on how to build up my pot. That extra £10 here and there that could make all the difference.

However, just as important as building up a sizeable pot is what you do with that pot when you come to retire. And many of us stump for one of two options - a lifetime annuity or an income drawdown scheme.

The trouble is, going for either of these options could end up being a very expensive mistake. Find out why - and more about the alternative options you should also be considering.

Lifetime annuity

When the time comes to retire, the vast majority of us turn to a lifetime annuity - around 425,000 in 2008, according to the Association of British Insurers. Basically, you hand over your pension pot, in exchange for a monthly income for the rest of your life from an annuity provider (usually a life insurance firm).

The actual rate and type of annuity you are offered depends on a wide range of factors, including interest rates at the time and your health - if you are a smoker, for example, you are likely to get an enhanced annuity, and therefore a higher rate of income for the simple reason that you are likely to die earlier.

Similarly, impaired life annuities are available to those people with medical conditions that will reduce their life expectancy, and pay out a fair bit more each month.

However, there are a few problems with this system. For a start, you are locked in - once you sign up, that's it, you can't switch to a different deal. So if you get a standard lifetime annuity, and three months later have a heart attck, that's just tough luck.

Also, not all annuities allow you to pass on your pension money to your loved ones when you die - the money instead goes to the annuity provider.

Even worse, annuity rates have plummeted to record lows in recent times. According to Moneyfacts, the average 65 year old male level without guarantee annuity rate has plunged almost 30% in the last decade.

For many, annuities don't exactly offer a tempting option.

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Income drawdown

The second main option that the rest of us will go for in retirement is income drawdown. Basically, you keep your retirement fund invested in the markets, and take an income from it each year.

This can only be used until the age of 75, at which point an annuity has to be bought, or the money moved into an alternatively secured pension (essentially the same as income drawdown, but with additional rules on how much you can withdraw as an income).

How much you drawdown from your pension is really up to you. If you are 50, chances are you may not want to start getting your pension, so you can keep the income at 0% for a while, keeping your fund fully invested.

The big advantages are obvious - you can pick and choose exactly when to move to an annuity. This means you can get the best possible deal for you, at a time when your investments are looking good and annuities are at a sufficient rate to give you the income you want.

However, as markets go down as well as up, that advantage is also the scheme's biggest flaw. With significant stock market fluctuations over the past few years, an awful lot of Brits who have gone for the income drawdown option are having sleepless nights over losing their all of the money they've put aside over the years.

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The third way

Neither of these options strike me as particularly appealing. However, there is a little-known third way which might just provide a happy balance for many of you: fixed term annuities.

Fixed term annuities are not quite new - they've been around for a few years now - but they are massively ignored, by providers and pensioners alike. Currently just Living Time and LV= offer such products, and even LV= have only been in the market a matter of weeks. But this is a good sign, as it means competition is heating up.

As the name suggests, a fixed term annuity covers you for a set period, anything from a couple of years up to however long before you reach the age of 75.

You then choose what income level you want to receive over that sed period of the annuity, and crucially, the provider will tell you exactly how much cash you will get back at the end of the term to then buy another annuity. Both of these figures are completely guaranteed.

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Keeping things flexible

In many cases, going for a fixed term annuity won't result in an initial benefit - in many cases the annuity rate you get will actually be lower than if you went for a lifetime annuity.

However, it's the flexibility that is crucial. If you get an annuity at 60, most of the time you will be medically fine, and so only qualify for a standard lifetime annuity. However, with a fixed term annuity, you could choose to wait until you reach, say, 75 before you shop around for a lifetime annuity. And by that point, 50% of us will have something medically significant wrong with us.

I appreciate it sounds odd to view this as a good thing, but it does mean that you will qualify for a much more attractive annuity - some enhanced annuities pay up to 75% more than a standard lifetime annuity would, according to Living Time. That means you'll be looking at a far more comfortable retirement than if you had lumped for a normal lifetime annuity at 65.

The big plus of a fixed rate annuity vis-a-vis income drawdown is that you don't have to worry about stock market volatility damaging your pension pot at the very last minute, the way it did in 2008 and 2009 for many who took this option. You get the security of a lifetime annuity, but without being locked in forever. And for those who prefer to keep their money invested, it can't hurt to put at least some money aside in a fixed term annuity as a contingency plan, should things go wrong in the markets.

Hopefully the entrance of LV= into the market will encourage some of the other big annuity providers to start offering this important product. It may not be the ideal option for everyone, but in my view it offers an important bridge between the existing annuity options.

What do you think? Please leave your comments below.

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