Making the right choice is crucial; PLANNING to finance your retirement is far from simple. IAN LOWES gives some guidance through the maze of options.
WE are all growing older - and by that I mean not just as individuals but on a demographic basis in the UK. Whereas a few years ago someone ceasing employment at age 65 would be looking at a retirement of 5-10 years, improvements in our lifestyles and in health care mean that these days the average person could be looking at a retirement of 20 to 30 years.
Therefore, finding the right retirement product to provide the best income for that period of time is crucial. Indeed, making the wrong choice could see you worse off by thousands of pounds a year.
Most people in the UK saving for their retirement end up with a pension pot which they can use to buy a retirement income product. There are actually 10 products available in the market but two currently dominate - the lifetime annuity and income drawdown.
The lifetime annuity is, as the name suggests, a product which undertakes to take your pension pot and to pay you a regular income until you die.
This is a long-term contract which suits a great many people. It has two drawbacks, first, it is a contract for life, so once signed there is no going back; second, when you die the insurance company can keep the rest of your pension pot, whether you live for two or 20 years (unless a joint annuity is taken out - see below).
The important point to remember with an annuity is that there are many of them in the market all paying different rates of income. Many people when approaching retirement simply accept the annuity quote provided by their pension provider without realising they might be able to get a significantly higher income from having an adviser shop around for them. Ensuring you compare the market to get the best rate before signing on the dotted line is essential.
Income drawdown enables retirees to draw an income from their pension pot while keeping it invested in the stock market, to take advantage of investment opportunities. This product is generally considered suitable for larger pension pots and, of course, has investment risk attached, which could see the value of the pot go down in adverse market conditions.
Anyone contemplating annuity purchase should first consider the following points: You can take up to 25% of your pension fund as tax-free cash - the pension income from the annuity will be taxed at your marginal rate of income tax.
If you have more than one pension fund you might consider consolidating them into a single fund rather than buy separate annuities. Larger funds can benefit from higher annuity rates.
If the value of your total pension rights is below a certain level - pounds 18,000 for the 2010-2011 tax year - you may be able to exchange them for a cash sum, subject to tax on three quarters of it.
Once these points have been taken into account, there are several different types of lifetime annuity to consider. The key ones are index-linked, where income rises over time to compensate for inflation, and joint-life, where your spouse receives at least part of your pension when you die.
Other important variations you should be aware of are impaired life or enhanced annuities, and postcode annuities.
If you have health problems which could reduce your life expectancy (eg heart disease, cancer, or stroke), then some providers offer impaired life annuities which may provide a higher income. These may be available if you are overweight, or smoke regularly, and some companies also offer higher rates to people who have worked in certain occupations.
With postcode annuities, the income offered is based on where the customer lives. eg Kilbernie in Scotland is rated by actuaries as the place where retirees have the shortest life-span, and residents there may receive annuity payments up to 10% higher than paid to people in other areas.
Other products include variable annuities, which are a hybrid between a lifetime (or guaranteed) annuity and an income drawdown product. Likewise, fixed-term annuities are a short-term annuity product that pays a regular income for a set period and then gives the rest of your pension pot back, so giving the flexibility to make a longer-term decision further down the line.
People relying on a regular, dependable income from a smaller pension pot - under pounds 50,000 - may not suit many of the product alternatives to lifetime annuities as they will not want to take investment risk and switching products will incur costs. Those with larger sums to invest should consider the range of options.
From the above it can be seen that choosing the right income product at retirement is vitally important. Ensure you consider what the market has to offer before committing yourself to a particular product. An independent financial adviser can help you in that process and in choosing the right solution for your circumstances.
Ian Lowes is managing director of Lowes Financial Management in Gosforth, Newcastle
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