Pension incomes could rise 10%

Updated: 

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Finally there's great news for people about to retire: changes in the markets mean that the income you'll get from your pension may well increase by anything up to 10% in the next few years.

But why the change, and what does it mean for you?



The change

When you retire, if you have a defined contribution pension (also known as a money purchase, a personal pension, a group personal pension or a stakeholder pension) you will have built up a pot of cash.

At retirement, you can either choose to draw down small chunks of that cash directly each month (known as draw-down), or opt for the far more common option of buying an annuity - which swaps the lump sum for a monthly payment for the rest of your life.

For years now the amount of income you can get for the same lump sum has been falling steadily, partly as a result of the fact we're all living longer, and partly as a result of movements in the financial markets.

Recently the financial markets changed, however, and started moving in the opposite direction - which may mean that we will see incomes rise.

The markets in question are the government bond markets. Annuities are driven in part by the interest rate paid on 15-year government bonds. This interest has been falling rapidly because government bonds have been in particularly high demand in troubled times, which means the government hasn't had to pay out so much interest in order to get people to lend it money.

Now it has started to rise. At the bottom of the market, the interest rate was 2.06%. Now it's 2.6%. According to the Telegraph, the experts are predicting a rise to 3.2% within the next two years. This would equate to an 11% rise in annuity rates - or an 11% rise in the income you could buy with your pension pot.

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Should you put off buying an annuity?

It sounds like excellent news, so should we be breaking out the champagne, and defer taking an annuity for a couple of years in order to take advantage of the huge leap in income?

Tom McPhail, head of pensions research at Hargreaves Lansdown, isn't so sure. He points out that the rise in the interest paid on these bonds has so far been "marginal". He agrees that if they were to rise as the Telegraph's experts have predicted, then annuity rates would rise, but he is not convinced that this is guaranteed, and he says the rises so far have not been significant. He says: "We shouldn't get carried away by this. Yes annuity rates will go up, but we don't know when and we don't know how much."

Not only is he less certain that the yields on government bonds are set to soar. He also highlights that annuity rates are also driven by inflation, and there's a broad consensus that inflation isn't going anywhere for the next couple of years at the very least.


Risks

He says: "I am worried that people will defer taking an annuity in the hope that rates improve. There's the question of what they live on in the meantime. Some will keep working, but others will have to take the lump sum or put the money into draw-down. Unless you have a six figure pension pot that's a very short-term solution."

"Then there's the question of where they put the pension pot while they are waiting. If it's a short term strategy then they'll need to keep it in cash, and what return will they get on that? 0.5%? And all the time they'll need to pay charges on it, so the pot will erode further."

If a 65-year-old man chose to defer today, waited for four years for rates to improve, and then gave up and bought an annuity at today's rate, McPhail says that he would have to reach the age of 93 before breaking even on his decision - which is a lot to ask given that life expectancy for men is currently 86.

If you defer annuitising and annuity rates increase dramatically in the interim, you will earn more income, but you are taking a real risk.

One option, McPhail says, is to partially annuitise now, and then annuitise the rest in a few years, in order to counteract the uncertainty in the market. He says: "I don't disagree that rates will go up at some point. But that doesn't necessarily mean you ought to put off buying an annuity: it's not that simple."

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