Thousands of Britons reaching retirement each year use their hard-saved pension pot to buy an annuity, a financial plan that will give them a guaranteed income for the rest of their lives. But experts have warned that many pensioners will never get back all the money that they put in.
Pension savers often only come across annuities when they are getting close to retirement and need to convert the money they have built up into an income. If you belong to a final salary scheme, your pension is usually paid directly from the scheme so annuities are not something you will have to think about, but these “gold-plated” final salary pensions are becoming thin on the ground these days.
Annuity rates are set by insurance companies and buying one is a long-term investment decision as it will give you a fixed annual income for life. This is a double-edged sword though - locking into an annuity gives you certainty about how much money you will have to live on throughout your retirement, but also means that this fixed income may not take any later unexpected changes in your circumstances into account. For example, if you die soon after buying an annuity, you will have received much less money than you paid in.
This should make us consider very carefully how we will provide for our old age, something that is thankfully being addressed by new landmark Government reforms, where over one million extra people have now been placed into workplace pension schemes.
The reforms are already being hailed a success, and up to nine million people are expected to either start a pension or begin saving more over the next five years as a direct result.
This big retirement saving drive aims to head off a looming pensions crisis, amid fears that people are living for longer but not putting aside enough for their later years. Many of us can now expect to enjoy well over 20 years in retirement, perhaps longer than we spend paying off our mortgages.
:: But is simply saving into a pension enough to produce a decent retirement income?
Ros Altmann, a former Downing Street pensions adviser, recently sparked a major debate by revealing the findings of new research about annuities, which are purchased by 400,000 people each year.
Dr Altmann, a former director-general of over-50s group Saga, is concerned that pensioners could be taking on “the biggest gamble” of their lives.
She says that many people buying an annuity at 65 will not see any return on their money before they reach the age of 82 and will have to live until the ripe old age of 90 before their purchase becomes “good value”.
Annuity rates have been in general decline in recent years as people live for longer. Pensions experts have also put the drops down to side-effects of the Bank of England’s efforts to kick-start the economy.
Dr Altmann says: “Buying an annuity is considered the ‘safe’ thing to do when reaching retirement. This is misguided. The ‘safety’ only means that the amount of income will be set for the rest of your life.”
If you purchase an annuity when you are still aged in your 60s - a relatively young age these days - and are in good health, you may run the risk of your income not reflecting a change in circumstances if you later become ill.
Annuities for the chronically sick generally pay more because those buying them are likely to have a shorter life expectancy.
Dr Altmann is urging the industry to give buyers more “proper risk warnings”.
:: So how can you get the most from an annuity?
The most important piece of advice is to shop around, an estimated £1 billion in potential retirement income is “thrown away” each year because people fail to do this.
There are a range of products for those with different needs, and the best deal for one person may not be right for someone else.
The Association of British Insurers (ABI) has just started placing examples of the rates people could expect to get in different scenarios on its website at www.abi.org.uk/annuities.
The initiative aims to give people approaching retirement a clearer picture of what they might gain by shopping around.
Steve Gay, director of life, savings and protection at the ABI, says: “Rising life expectancy and the era of low interest rates make securing an adequate retirement income more challenging than ever.
“The answer is to save as much as possible during our working lives and to shop around for the best possible annuity deal for your circumstances.
“The alternatives risk a retirement of financial struggle and uncertainty.”
:: What types of annuity are there?
The most simple type of annuity offers an income to you alone; a “single life” annuity that pays you a fixed income until you die. A “joint annuity” will continue to pay some money to your partner after your death.
However, there are some trade-offs to bear in mind with joint annuities such as the possibility of lower rates. If your partner is younger than you, this could also impact on the rate you will be offered as the insurance company will expect to be paying out an income for longer.
As annuity rates are tailored to how long you are expected to live for, it might be worth considering an “enhanced” annuity, which offers a higher rate to people with lower life expectancies. People who could qualify for such annuities include those with health problems, overweight people and those who smoke heavily.
Annuities tend to pay people until they die, but it is also possible to buy fixed-term annuities which last for a set period of years.
A possible alternative option to buying an annuity could be income drawdown. This involves withdrawing an income from your pension savings while the remainder remains invested, so you can continue to benefit from any growth.