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Your pension and rising rates: how to capture the highest possible income for life

Sam Brodbeck
Avoid 'buyers' remorse' by following our three strategies - A Richard Allen

All things point to a rise in the Bank Rate – and savings and annuity rates are already creeping up in anticipation. Anyone who wants to buy an annuity, an insurance contract that pays an income for life, with their pension pot will be desperate to avoid “buyers’ remorse”: buying now and then regretting it if rates improve.

There are several practical ways in which annuity buyers can reduce this risk. They could buy a “fixed-term” annuity; they could wait until rates rise (and they age); or they could do something in between.

Buying annuities in stages, once a month over five months for instance, could result in a 6pc income boost, according to figures produced by Retirement Advantage, the pension firm, for Telegraph Money.

The number of people who use annuities to fund their retirement has plunged since a series of reforms made it far more appealing for them to keep their pension savings invested into retirement and “draw down” an income.

But for millions of people with fixed living costs and no experience or appetite for investing, annuities are highly appealing. The problem is that rates have been falling for years as they are driven by the yields on government bonds, which have dropped to record lows since the financial crisis.

A decade ago, £100,000 would have bought a 65-year-old around £7,500 a year in guaranteed income. But at today’s rates the same sum would yield barely £5,500.

Most pensioners who live off annuities bought a single contract in one go, but now that rates are starting to climb, that makes less sense. Conventional annuities pay a flat amount for life and even “escalating” versions increase only by a prescribed percentage or the rate of inflation. Initial incomes are even lower on the latter annuities.

“People considering a lifetime income will at some point face the annuity conundrum: when is the right time to buy?” said Andrew Tully of Retirement Advantage.

“Trying to time the market is impossible, and you can just as easily choose the worst time to buy as the best. It often makes sense to buy annuities later in life, as rates will be better. If your health deteriorates, this can also improve your income. Buying in phases creates the flexibility to take advantage when rates improve, or to choose different versions if your circumstances change.”

We’ve devised three strategies for people caught in this dilemma. We assume a pot of £250,000. Of course, there is always the chance that rates remain static or fall, in which case it would have been preferable to lock in at today’s rates.

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1. Secure an income for now – and fix for life later

It is possible to buy an annuity that will pay out for a given number of years, typically five or 10, before returning a fixed sum at the end of the period. As with lifetime annuities, you can choose a contract that covers one person or a couple and one that pays a flat or escalating amount.

If you think annuity rates are likely to rise in a few years, this option ensures that you have a guaranteed income to cover essential spending and a lump sum at the end to buy another annuity once rates have shown improvement.

And if rates have not risen sufficiently, pension rules allow savers to keep the money invested instead and draw an income from dividends and capital gains.

A word of warning. Competition in the fixed-term annuity market is not as strong as between providers of conventional annuities as there are far fewer firms still active. With Legal & General, the best-known provider, a £250,000 pot would pay a 65-year-old £22,500 a year for a five-year fixed term, paying a lump sum of £150,000 on maturity.

2. Live on other assets and buy when you’re older

Annuity firms base rates on bond yields and how long they think a customer will live. Holding off buying an annuity in early retirement can give a dramatic boost to the income paid as the insurer can expect to pay out for fewer years. For a 65-year-old at today’s rates, a £250,000 pot would buy £12,925 a year for life. The same pot would buy an income of £15,075 if purchased at 70 instead, according to Retirement IQ, an annuity specialist.

However, according to Retirement IQ’s Billy Burrows, delaying could increase your income in other ways. Older people are more likely to develop medical conditions that could qualify them for an enhanced (or “impaired-life”) annuity.

These pay higher incomes for illnesses that may shorten your life. Conditions such as high blood pressure can give a 2pc uplift, while more serious health problems, such as cancer or strokes, can increase payments by as much as 50pc or 60pc.

There is also a greater chance that your partner or spouse will have died by the time you buy an annuity in later life. A “single-life” annuity will pay more than one that covers two people, again because payments are likely to be due for a shorter period.

There is also a tax argument for buying annuities when you’re older. Tax rules impose an arbitrary “cliff edge” at age 75. Before that age, unspent pensions (not those already used to buy an annuity) are passed on tax-free. If death occurs after 75, however, income tax is due in line with the inheritor’s marginal rate. Therefore, after this age there is less incentive to keep pension money invested.

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3. Buy in stages to bank higher rates

“Drip feeding” is one of the basic principles of investing. The idea is that buying a particular asset each month, rather than in one go, reduces the risk of investing at the top of the market. A similar strategy can be applied to purchasing annuities.

In August 2016, £250,000 would have bought an annuity that paid £11,725 a year. However, if that same sum had been split into £50,000 chunks and each used to buy an annuity over five months, total income would have been 6pc higher, at £12,395, according to Retirement Advantage. Over a typical 25-year retirement that means an extra £16,750 of income.

Of course, the boost was achieved only because rates happened to rise over the period in question.

If the entire pot had been used to buy an annuity in January 2016, for example, it would have yielded £14,025 – far more than in either of the other scenarios.

But the principles described in the previous two strategies can also be applied here.

You could buy in stages but spread them out over a longer period to take advantage of higher rates for older customers, as described above.

And the death of a spouse or worsening health could boost incomes further.

Mr Tully said: “With the phasing approach there is more flexibility around the exact terms. If I bought an annuity that provided a spouse’s pension and my spouse died shortly afterwards, that would effectively be a ‘wasted’ benefit. If I bought annuities in phases, I could choose the ‘death benefits’ each time to be appropriate to my circumstances.”

sam.brodbeck@telegraph.co.uk

Reader Service: Carefully review your existing pension arrangements with theTelegraph Investments and Pensions Service