Make this awful mistake with your pension and you could lose 20% or more of your retirement income every year.
Welcome to Pensions Day, where we'll be taking a really close look at one of the most crucial financial topics. If you're new to pensions, make sure you check out lovemoney.com commentator, Ed Bowsher's blog which will tell you how to become a pensions expert in five days!
Retirement should be a time you look forward to when you're finally done with the daily grind. So, with all this extra leisure time on your hands, it's really important your pension pot stretches as far as it can.
Luckily, there are some pretty easy ways you can do that. The trouble is, most people have never even heard of them. In fact, new research from annuity company, Just Retirement, shows three in four people are still missing out on vital extra income in their twilight years.
So, here's how to make the most of your pension:
Standard annuities
When you retire, you'll probably take benefits from your pension using an annuity. An annuity converts your pension fund into an income stream. The amount of income you'll get depends on prevailing annuity rates at that time.
Annuity rates are influenced by several things including your age and gender, as well as economic factors such as interest rates and the yield on gilts (government debt) and corporate bonds (company debt).
But let's not worry about that too much. Quite simply, the higher the annuity rate, the better the income. So, what you need to do is hunt down the most competitive rate you can find. But how do you do that?
Open market option
One thing you must never do is blindly accept the first annuity your pension company offers you without shopping around for a more generous alternative. This is where most people go wrong.
Each annuity company sets its own annuity rates, so it follows that some will be better than others.
Shopping around for an annuity is known as exercising the 'open market option'. You can do this in two ways: Get help from an independent financial adviser who will search the annuity market for you to find the best deal (although you'll need to pay for their advice). Or, check out the rates yourself online using websites such as the Financial Services Authority or the Annuity Supermarket. Or, you can do both!
You'll be surprised how much difference using the open market option can make. For example, let's imagine you're a 65-year old man. Based on today's rates, the most competitive standard level annuity rate for you is 6.8%, while the least competitive is just 5.69%.
This means, if you had a pension pot of £100,000, your income could range from £6,800 a year at best to £5,690 a year at worst. That's a difference of £1,110 every year for the rest of your life.
Now imagine you live for 20 years after retiring. Over that period, the top annuity would give you an extra overall income of £22,250 - or 20% more. I think you'll agree that's quite a bonus in return for a few minutes of shopping around.
So - just to remind you - you're under no obligation whatsoever to take the annuity from your pension company. Chances are, it won't be the best annuity you can find.
Boosting your annuity
So, we've seen how you could get an extra 20% out of your pension. But, you might be able to boost your annuity income even more based on your life expectancy. If your life expectancy is lower than average, it's assumed your annuity will pay out for a shorter period, giving you less income overall. For this reason you could be compensated with a better annuity rate. Here's how:
Smoker annuities
If you smoke then you should shop around for a 'smoker annuity'. Naturally, a smoker is expected to have a shorter life expectancy than a non-smoker. And this is reflected in the higher rates available from these specialist annuity plans.
The most competitive smoker annuity offers a rate of 7.83% (again, for a 65-year old male). This would provide a yearly income of £7,830 based on a £100,000 pension pot. Remember, the top standard annuity only offered you an annual income of £6,800 and the worst offered an annual income of £5,690.
So, by shopping around and choosing the best smoker rate, you could gain up to £2,140 extra in your pocket every year for the rest of your life. That's up to an extra 38% a year!
Enhanced annuities & impaired life annuities
Enhanced annuities work in a similar way to smoker annuities. But this time you might benefit from a better rate based on a medical condition. For instance, if you suffer from any of the following, then an enhanced annuity could provide a more generous income:
- High cholesterol or blood pressure
- Diabetes (insulin dependent)
- Obesity
- Emphysema
- Stroke
- Heart attack
Just Retirement estimate this could give you up to 33% more than you would get from a standard annuity.
If you're in very poor health, and your life expectancy is significantly lower than average, you should think about an 'impaired life annuity'. With these annuities, you could earn a much higher income if you suffer from a very serious condition such as chronic heart or lung disease, some forms of cancer or motor neurone disease. This could increase your income by up to 60% more than a standard annuity.
Postcode annuities
Finally, postcode annuities are a relatively new addition to the market. Alongside all the others factors which influence annuity rates, where you live is also taken into account. The idea is that you'll benefit from higher rates if you live in a deprived area where general life expectancy is lower.
On the other hand, if you live in a more affluent area, you may be penalised with lower rates because your annuity is expected to pay out for longer. So take this into consideration if you're thinking of moving house before buying your annuity - and do the maths first. You may get a slightly better deal if you buy your annuity while living in a less affluent postcode.
Mind you, the difference is unlikely to be as significant as some of the other factors mentioned above. The key thing is really to shop around, and to ensure any medical problems you suffer from are taken into account. Then you really could make a packet out of your pension!
More: Six ways to boost your pension income | Why delaying your retirement makes sense