Could You Increase Your Pension Income By Half?
Before you buy an income with your pension pot on the open market, make sure you don't lose out on valuable benefits which may be offered by your pension provider.
If you're a regular reader of The Fool you'll know we like to encourage you to shop around at every appropriate opportunity. And if you're after just about any personal finance product this is certainly sound advice. But when it comes to buying an annuity you need to exercise extra caution because that decision will affect the rest of your life.
Annuities enable you to convert your pension pot into an income which will support you during your retirement. The level of income you'll receive will depend on the annuity rates on offer at the time of the conversion and the format in which you choose to take your benefits. The problem is that annuity rates can vary dramatically from one insurer to another. Pick the wrong one and you could really lose out.
Once you've decided an annuity is the way to go, you usually have two choices:
- Take the annuity your existing pension provider is offering you or;
- Shop around and compare the market to make sure you've found a competitive annuity elsewhere before taking the plunge. In the pension industry they call this exercising your ‘open market option' or OMO.
Generally you'll be able to find better rates using the OMO, unless you're lucky enough to have your pension with an insurer who also happens to offer market-leading annuities. But, before you jump ship, take a good look at what your existing pension provider is offering you, particularly if you have an older-style pension as you may just find the benefits available outshine the rest of the market.
Guaranteed Annuity Rates
When you're ready to take an income from your pension you will be given a retirement quotation which outlines the benefits your provider is prepared to offer you. Check this document carefully as it will tell you whether your plan has a feature which could potentially prove extremely valuable: a GAR.
What's a GAR? Pension schemes written in the 1960s up to the mid 1980s routinely incorporated what's known as Guaranteed Annuity Rates (GARs). You may find some policies opened prior to that also include these potentially valuable benefits. Most commonly GARs were written into with-profits plans (where returns are smoothed) but they were occasionally included in some unit-linked schemes (where returns reflect the performance of the underlying fund) too.
A GAR obliges the provider to offer you a minimum predetermined annuity rate for your pension fund when it is converted into an income. GARs meant little when they were originally issued as, at that time, both inflation and annuity rates were high. But today, decades later, annuity rates are considerably lower than they used to be and therefore an older scheme that incorporates a GAR could potentially provide you with a higher income in retirement than you could secure on the open market.
So let's take a look at the figures. The most generous standard annuity for a 60 year-old male would provide an annuity rate today of around 6.7%, which means a pension pot of £100,000 will give you an annual income of £6,765.*
But pension plans which include GARs typically offer annuity rates in excess of 10%. If you happen to have one of these older plans and stick with it, you could enjoy an annual income of £10,000 - which is equivalent to an uplift of almost 48%.
What's the catch?
Sadly, there is, as always, a catch or two. Or three. Or four. So watch out:
- Firstly, plans with GARs often place restrictions on how you can take your pension income. Typically you may find your income can only be based on a single life. This means it will only provide payment to you and can't be used to provide a pension for your spouse after your death. For this reason, the GAR option could be fundamentally unsuitable for you.
- Secondly, with a GAR, you may not be able to take an income which escalates each year or increases in line with inflation.
- Thirdly, you might also find that ‘guarantee periods' are excluded. A guarantee period fixes the length of time over which your annuity will be paid in advance. Generally a guarantee period will last five or ten years regardless of whether you survive that long or not.
- Finally, you may only have the right to exercise a GAR at your selected retirement age. This means they can lack flexibility if you want to take benefits earlier or later than that.
And not all GARs are equal. They can vary greatly in terms of the annuity rates paid. A 10% rate is at the more generous end of the scale, but some contracts offer rates far below this level which may not compare favourably with the open market.
Nevertheless for those of you who are approaching your retirement now, make sure you check what your pension provider has on offer before looking elsewhere. Often we're unaware GARs have been built into the policy, so they can easily be overlooked.
The paperwork your pension provider sends you may not be particularly easy to decipher -- but please, stick with it. Once you know whether or not you have a GAR, and how valuable it is, then you can weigh up the pros and cons of such an option before deciding whether or not to switch to another plan.
Good luck and Bon Voyage!
*Source: Annuity Bureau. Annuity rate shown is single-life, level in payment with no guarantee period applying.