In a recent interview with the Daily Telegraph, Steve Webb, the pensions minister, spelled out his vision for an overhaul of how pensions work. The essence of his plan is that he wants pensioners to be able to switch to better annuities regularly in the same way that homeowners can change their mortgage deals every few years. The aim is to avoid the situation where pensioners are trapped in potentially poor-value schemes until they die.
Currently, the standard route for most people on retirement is to use their pension fund to buy an annuity, which then pays them an annual income for the rest of their lives. For many, it ranks as one of the biggest financial decisions they will make. However, in recent years annuity rates have plummeted, resulting in many people ending up in relatively poor-value schemes.
This is why, according to the Sunday Times, savers with larger pension funds have been turning their back on traditional annuities and have been taking up the income drawdown option. In 2011, the government abolished the compulsory purchase of an annuity, giving retirees more flexibility. Income drawdown allows savers to keep pensions invested and choose their level of income rather than hand the whole of their pension pot over to buy an annuity. The consensus is that income drawdown is likely to become more popular over the next few years.
Income drawdown can certainly offer greater flexibility. It also provides the potential of an increasing income and improved death benefits. However it is important that a retiree both understands and can live with the risks. Your pension remains invested and your future income depends on the performance of your investments. If they perform badly then your fund value and future income could fall, which could leave you short later in retirement. For most people it makes sense to have enough secure income from other sources, such as annuities or final salary pensions, before considering income drawdown.
Of course, if your investments do well, you could increase both your fund value and your maximum income, which would help against inflation. So income drawdown can be a good additional option for those with larger pension funds.
Whatever happens with Steve Webb’s annuity plans, there are already ways in which investors can improve their retirement income. The obvious one is not to just accept the annuity offered by your pension provider but to shop around, using what is termed the open market option.
The other one is to be open about your health and lifestyle. There are many conditions that could lead to enhanced annuities, such as smoking, drinking, high blood pressure, diabetes etc. These factors and more could lead to you receiving a higher income for the rest of your life.