'Beware annuity purchase delay', as retirement income drops

Annuity rates – which determine the income you get when you cash in your pension on retirement – have been falling for about ten years.

On the basis what goes down usually goes up at some point, what is the prospect for a rise any time soon?

The answer is that rates probably won't rise soon which means a tough choice for many.

As we know, people are living longer, so people's pension funds have to last longer and that ultimately means rates are more likely to drop as providers won't be able to afford current payouts as they'll be paying out for much longer.

What's more, medical science is constantly improving and so with longer life comes lower annuity rates as annuity providers won't be able to afford to pay out for longer periods.

Remember, the actuaries have to calculate how long you will live when you hand over your pension fund and they will take account of improvements in life expectancy.

Will interest rates make a difference?

Then there are interest rates. They must go up eventually which will in turn increase annuity rates. Well, yes. But when?

The economy is going through a difficult time and low interest rates have traditionally been the classic stimulus. In the foreseeable future – by which I mean a year – do you really see a rise in rates? No is probably the answer.

And there's more. Quantitative easing (QE), which involves the Government printing money, has an impact on annuity rates. Why that happens is very complicated but the end result is a fall in annuity rates.

The last round of QE has resulted in yet another frenzied annuity rate reduction. If we have more QE in coming months, then sadly expect more falls.

There is also a European influence. In December 2012 all rates will have to be unisex.

This will result in a fall of an estimated 6% in male rates and a rise in female rates, as men tend to get more now as they tend to die earlier, although it is debatable as to how much the rise in female rates will be.

In 2013, a European instrument called Solvency 2 hits us. This harmonises EU insurance regulation, primarily this concerns the amount of cash companies must hold to reduce the risk of going bust.

Consequently, after a complex sequence of events, annuity rates will become based on the rate of return on a different investment instrument – gilts rather than corporate bonds.

The net result is probably lower annuity rates as gilts tend to pay less. The expected impact is a reduction in annuity rates of between 10% and 20%.

What should you do?

So, amidst the bad news, the big question is: what can you do?

Most people's instinct is to defer buying an annuity but in doing that they give up income in the hope that they will eventually get this back from a higher annuity. Yet if rates fall further this could be a bad choice.

If you don't decide to defer you also have to think about where the fund is invested.

The markets are very volatile and you could end up with a lower fund, a lower annuity rate and lost income – a triple whammy if ever I saw one.

It is possible to buy annuities over a number of years to average the rate. If you do this you could use tax free cash each year as income. This is known as a phased purchase.

Income drawdown, where you gradually take cash from your pension pot, is an option but again you are at the mercy of the markets as the money is still invested.

A simple test is to ask yourself if you can afford to reduce your income to zero in the event of market falls. If the answer is no, then drawdown is probably not right for you.

There is no easy answer other than proceed with care and understand why you are taking a course of action – and of course, shop around.

Views expressed are not necessarily those of MoneySavingExpert.com.