Although we are in a new pension regime that allows income flexibility for people with large pension pots, in practice most people will still need to buy an annuity at retirement. But they then face the problem of what type of annuity to buy - and each of the options is far from perfect.
The alternative to annuities is drawing an income directly from your pension pot. This can be done with complete flexibility if you can first secure £20,000 of pension income (only the wealthiest 0.5 per cent of the population will be able to do so). If you can't secure £20,000, then you have the option of capped drawdown, which enables you to withdraw an amount equivalent to an annuity directly from your pot. However, according to research by the Pension Policy Institute (PPI), in 2010 the vast majority of people aged between 55 and 75 would not have had a large enough private pension pot to be able to bear the investment and longevity risks associated with capped drawdown.
The PPI report says that, although there is no regulatory restriction on the size of pension pot a person needs to enter income drawdown, many independent financial advisers (IFAs) argue that people need a pension pot of a minimum of between £100,000 and £250,000 to ensure they can bear the investment risk and longevity risk associated with drawdown.
Those that don't have that much will have to buy an annuity. Level annuities offer the highest starting income (today the best rate is £6,867 for a male aged 65 with a £100,000 pension pot). However, the purchasing power of level annuities can be quickly eroded by inflation.
So why not go for an inflation-linked annuity? The problem here is that inflation-linked annuities are expensive so you start at a much lower rate and it takes too long for rates to catch up with level annuities. According to Billy Burrows, the founder of William Burrows Annuities, the starting income from an inflation-linked annuity is some 40 per cent lower than a level annuity and it takes over 14 years to overtake the level annuity and over 25 years for the total payouts to be the same.
Enter the third breed of annuity - the investment-linked annuity, sales of which are soaring. An investment-linked annuity combines the advantages of an income for life with the advantages of investing in the stock market through a selection of underlying funds. They offer the potential for future income growth, income flexibility, plus usually a minimum income guarantee.
However, Annuity Direct says on its website, that as a general rule, a fund needs to achieve at least 7 per cent a year growth after charges for the income from an investment-linked annuity to be enough to beat a guaranteed annuity. Charges can add up to 2 per cent a year onto the performance your annuity needs to achieve. That means your fund needs to make 9 per cent a year to beat a guaranteed annuity. It's starting to seem like a bit of a gamble.
Also, annuity advisers say that you should not consider a unit-linked annuity unless you can cope with an income that can swing widely and may fall. That sounds like similar risks to drawdown, under which your income might have to fluctuate depending on how your underlying capital performs. But income drawdown has a wider choice of investments than with an investment-linked annuity that is limited to a handful of open-ended funds. The downside is that in income drawdown you miss out on the benefits of mortality cross-subsidy - the process of pooling the funds of annuity policyholders who have died earlier than expected and sharing these among remaining customers.
Chartwell Financial Services says investment annuities usually have higher charges than other annuities. So a chunk of your fund could disappear in up-front and annual charges. They're starting to sound like a bad deal to me.
On the other hand, income drawdown isn't cheap, either; with older plans it was quite common for investors to be charged set-up and annual fees of hundreds of pounds. However, newer low-cost providers have made the cost of income drawdown more reasonable. Sippdeal charges a set-up fee of £150 + VAT and an annual administration charge of £75 +VAT (under 75s), while Hargreaves Lansdown charges no set-up or annual administration fees.
None of these 'at retirement' income decisions are easy. And they are decisions that are difficult or impossible to change once taken. So we recommend taking independent financial advice at the point at which you need to generate income from your pension pot. You can search for an independent financial adviser in your area here.