How to fight dwindling annuity rates

It's hard to imagine a worse time to retire.

People stopping work now are faced with a perfect storm: pension pots damaged by the past months of stockmarket volatility; gilt yields at a record low level, which have pulled annuity rates down with them; income drawdown options hit not only by those falling gilt yields but also by recent government restrictions reducing the amount of drawdown that can be taken each year.

To cap it all, Consumer Prices Index (CPI) inflation is bubbling along at 4.8%, further eroding the value of their already reduced pensions, while non-pension savings held in cash accounts at the current sub-inflation rates are also losing ground in real terms.

Given the UK's ageing population as the baby-boomer bulge comes of pensionable age, plus our ever-increasing life expectancy, some radical rethinking is clearly needed around the whole issue of retirement funding.

That involves a tranche of factors: a truly 'open market' for when it comes to arranging a retirement income; better pension education and a much less passive, laissez-faire attitude to their pensions on the part of many people; innovative retirement income products providing a more flexible income stream; a concerted long-term effort by government to get people to save enough to narrow the 'pension gap' between what they need to be comfortable and the income they're likely to have in reality.

But grassroots change, as ever, is painfully slow. Below, we take a look at the various options and strategies that could help to boost income levels for people retiring in the near future, and for those with much longer to go.

A better choice of retirement income

If you have just retired or are about to, there is little hope of a miraculous turnaround in circumstances. With UK pension pots averaging just £25,000, annuities are the only option for most people; but a 65-year-old man with a pension fund of £25,000 will now receive an income of just £1,564 a year - down from £1,683 in July this year.

That begs the question: should you defer in hope of growth in your pension fund or a pick-up in annuity rates as and when bond yields rise again? It's a big risk, says Jim Boyd, director of corporate affairs at specialist annuity provider Partnership. "The major risks of not locking into an annuity now, however rotten the rate may seem, are first that annuity rates may have got worse by the time you finally purchase one and, secondly, that the value of your fund may fall."

Indeed, Bob Bullivant, chief executive of retirement planning specialist Annuity Direct, points out that the introduction of unisex rates in 2012 and Solvency II legislation covering insurance firms' capital adequacy in early 2013, will tend to keep annuity rates depressed. "Rather than deferring, it's more important to buy the right kind of annuity considering your health and circumstances, looking across the whole market," he says.

Historically, however, many people coming up to retirement have been quite happy to flop straight into the mediocre annuity rate offered by their pension fund provider - all too often losing out on many thousands of pounds of lifetime income in the process.

There have been some industry efforts to push people towards a more proactive attitude: most recently, from January 2012 the Association of British Insurers (ABI) no longer allows member insurance companies to include an annuity application form with the information packs they send out to pension holders. But, says Bullivant: "I've not yet met anyone who thinks the ABI has gone far enough."

At Prudential, head of business development Vince Smith-Hughes admits that although there's more educational information in the public arena, "it's the current economic climate that is really pushing people to shop around".

People also need to look beyond conventional lifetime annuities to more flexible alternatives that enable them to adjust income to their changing needs.

These take various forms. For example, fixed-term annuities last five or 10 years; when the term ends, the annuitant can buy another fixed-term or conventional annuity at a rate reflecting their age, changes in health and general annuity rates at that point.

There is also a range of flexible investment-linked annuities on the market, such as that from Prudential. Investors have to be prepared to take an element of investment risk; but as Smith-Hughes points out: "Against that, conventional annuitants are faced with the risk that their income will be eroded by inflation."

However, as the market becomes more complex, it becomes all the more important that people take professional advice. Provision needs to be made for impartial advice to be available to everyone, regardless of the size of their pension pot.

Drawdown difficulties

Those with larger pension pots have the option of leaving their fund invested and drawing an income stream from it. Historically, £100,000 has been quoted as a starting point for drawdown, although as Smith-Hughes highlights, it depends very much on whether you have other income sources.

But here too trouble has struck hard: the maximum amount you can drawdown is linked to the Government Actuary's Department (GAD) rate, and that, in turn, reflects gilt yields. As these have bombed, the GAD rate has dropped to a new low of 2.5% of a fund's value. Moreover, under changes to the drawdown rules, the maximum drawdown has been lowered, from 120% to 100% of a comparable annuity.

As Mary Stewart, director of SIPP provider Hornbuckle Mitchell, explains: "The 2.5% rate limits a 65-year-old man with a £100,000 pension fund to taking a maximum of £5,600 a year from the fund. This compares to £8,400 in March 2011, when gilt rates were higher and before new restrictions were introduced - a fall of a third."

Those already in drawdown could be particularly hard hit, as they've become used to a relatively generous level of income and could see a significant fall when their drawdown arrangements come up for review.

Low-cost SIPP provider AJ Bell has been campaigning hard against the GAD reduction. "We have urged the government this year to reinstate the 120% factor and to review the link between gilt yields and pension income, and will continue to press the case," says marketing manager Billy Mackay.

But the consensus seems to be that the government will not reconsider; and indeed, that it would be foolish for them to do so. "A lot of people have seen big falls in their pension funds because of poor markets, so it wouldn't be sensible to enable them to take more again and rely on fund performance to make up the gap," says Smith-Hughes at Prudential.

The main option for those with at least £20,000 of pension income from other sources is flexible drawdown, which has no limit on the amount that can be taken from the fund. But very few are in that fortunate position.

There are two alternatives. "Those who have been in drawdown for some time may find that an enhanced annuity could produce a higher income if their health has deteriorated since they entered drawdown," suggests Jim Boyd.

Otherwise, the so-called scheme pension has recently gained traction, with a handful of schemes available from Rowanmoor, Axa Wealth and Hornbuckle Mitchell, among others.

Scheme pensions pay out directly from your pension fund like drawdown, but instead of relying on universal GAD rates for limits, an actuary sets bespoke upper and lower drawdown limits based on your personal life expectancy and attitude to risk. Those limits must be regularly reviewed by the actuary, so if your health has deteriorated the limits will rise.

"We launched this nearly four years ago, but it is this year that interest has really taken off, because the new drawdown rules makes it a potential solution for a much wider group," explains Stewart Dick, Hornbuckle's head of sales. "Before, it was mainly for wealthier retirees in declining health, but now the potential income available is higher than capped drawdown at all ages above 55, and for both men and women regardless of health."

Wider retirement planning

It's also important to take a broad view of your retirement income. That could mean mixing and matching pension income. "You could buy a secure lifetime or fixed-term annuity to pay the bills, and run a more speculative income drawdown scheme, or income from non-pension sources, alongside it," suggests Smith-Hughes.

The obvious choice in the latter respect for most people is income from an ISA portfolio. ISA investment works well in tandem with pensions: although they don't get the upfront tax relief, ISAs provide the flexibility and ease of access to capital that pension funds lack.

Moreover, ISA income is tax-free, which means that it is completely out of the equation as far as all tax considerations are concerned. So it won't push you into a higher tax bracket if you're teetering on the brink; nor will it count towards your personal tax allowance. And if you need capital at short notice, ISAs are easily accessed.

Early access to pension savings

On a longer perspective, the government is still wrestling with the thorny issue of how to boost pension contribution levels, especially among the less well-heeled. One idea that attracted much attention was to make pensions more flexible and less of a 'closed box', so people could access their savings if necessary before retirement.

Work done by the Pensions Policy Institute in 2008 suggested that yes, a flexible approach to pension saving could help encourage people to contribute up to 12% more. But in April 2011, following industry consultations, the government decided against that option.

It found there wasn't enough real evidence that people would increase their contributions if they could access those investments before retirement, and indeed that it might become too easy to raid their pension for short-term expenses, potentially leaving them even worse off once they retired.

Andy Zanelli, head of technical sales at Axa Wealth, explains the potential impact on a pension. "Say you allowed people early access to just their 25% tax-free lump sum. Someone who started saving a fixed sum into a pension at 35, aiming to retire at 65, but took out 25% as a tax-free lump sum after 10 years, would have to increase contributions by 29% from then on to make up the shortfall in retirement income."

For someone saving £200 a month into their pension, that would mean an extra £58 a month.

But the government has not ruled out the idea of early access in some form; the debate may continue after auto-enrolment has been introduced in 2012, particularly if a lot of people opt out of the new system.

One possibility is that, if necessary, employees should be able to access their own pension contributions, but not the tax relief or the employer's payments. Another is to somehow link ISAs and pensions.

Fidelity Worldwide Investments is one industry player backing this idea, arguing that ISAs are a familiar concept, and that if the two were linked, people would see that they did have considerable flexibility and could choose when to turn their money into pension savings.

In January 2011, Fidelity launched a 'workplace ISA' for employers to offer their employees; there's no employer contribution or other financial incentive for staff to use them, but they are convenient because contributions come directly out of their pay packets.

"Take-up so far has been encouraging," says head of marketing Rob Fisher. "We're seeing a slightly younger audience going for ISAs than for pensions, presumably because ISAs are more accessible at an age when they may need to get at their money."

Jeff Prestridge outlines his tax-efficient investment strategy in: Make 2012 the year of the ISA.