With so many of us living longer, planning for retirement is increasingly important. Legal & General, a large life assurance company, now assumes a 65-year old man will live for 25.1 years – giving him a life expectancy of just over 90 years. Women can expect to live even longer.
Deciding on our pension arrangements while we are in work might appear a chore but getting it right can mean the difference between scrimping in old age and living comfortably. One of the most important decisions for people who do not have a defined benefit pension from their former employer is to decide on an annuity. Annuities, which guarantee to pay you an income until you die, are the most common means of ensuring you are not penniless in old age.
Yet people often make poor choices about their pensions and suffer as a result. Many people facing retirement opt for their company’s "default" pension scheme option – the box they tick if they are not sure what to do. Nearly two-thirds choose a single-life, flat-rate annuity. Aon, a consultancy, calculates pensioners could be losing up to 30 per cent on the value of their pension pot or a cumulative £360m a year.
The first point to realise is that you are not restricted to any particular annuity provider when deciding where to put your money. You can shop around for the best deal from a wide range of companies.
Secondly, do not underestimate the length of time you may be drawing a pension. Many people opt for a flat-rate or level pension – which does not increase with inflation – because initially this pays out a higher amount. But inflation, which has recently been increasing steeply, will gnaw away insidiously at your pension and reduce your spending power. For many people an escalating annuity will be more appropriate. This can rise either at a fixed rate each year or by a percentage linked to the cost of living index.
This is a difficult choice to make because a flat-rate pension can appear so attractive at the outset. It would take around 14 years for an annuity escalating at a rate of 3 per cent a year to catch up with a flat-rate annuity and 26 years for before the total you receive from a 3 per cent annuity exceeds the total paid by a flat rate annuity. These numbers reflect the fact that the annuity provider wants to pay out roughly the same amount regardless of which option you choose, and until recently 26 years was a common calculation of life expectancy. However, if inflation speeds up, the escalating mortgage becomes a better deal much sooner.
The third big choice you have to make is whether to opt for a single or joint-life annuity. A single-life annuity dies with you, leaving nothing for your spouse, so pays out more than a joint-life. If you are single, your partner is much older than you, or they have their own pension arrangement, it may be sensible to opt for a single-life annuity. But if your partner does survive you, and has no other means of support, they could be left with nothing. You can compare the different options on the Financial Services Authority’s website at www.fsa.gov.uk.
By Charles Batchelor