There are several ways to cash in a pension pot for a monthly retirement income, but most of us will take a conventional annuity.
This is a guaranteed retirement income for the rest of your life. You can also usually take 25 per cent of your pot as a tax-free lump sum.
The downsides of a guaranteed income for life is that the income you receive is not very big. Most people retiring now receive around £5,000 to £6,000 per year for each £100,000 saved in their pension pot.
Also, when you die, your heirs don't inherit that pot, your annuity provider keeps it all.
Conventional “level annuities” also become less valuable over time. If prices rise at 3.5 per cent every year, in ten years time you'll need 40 per cent more income just to stand still – but your income stays the same.
And if we go through a period of high inflation your fixed income will be devalued even faster.
"Luxury" or rising annuities
There is an alternative conventional annuity called a “rising annuity”. This increases each year either by a fixed percentage or by the rate of inflation.
However, Tom McPhail, head of pensions research at financial service providers Hargreaves Lansdown, calls these a “luxury”.
This is because rising annuities start far lower. Instead of getting £5,000 to £6,000 per annum (pa) in the first year, you might just get £3,500.
If inflation rises at 3.5 per cent pa, it could take around 25 years before you have earned as much with a rising annuity as you earned with a level one, if you live that long.
It may also be you need more income earlier, because you'll be more active at the beginning of your retirement.
However, if inflation rises at 5 per cent pa, it might take just 15 to 20 years before you have earned more total income than with a level annuity.
In the 15 years from 1970, it averaged more than 10 per cent p.a. Since our nation has very serious debt problems and inflation is the easiest way out of them, another long period of high inflation is not beyond imagining.
McPhail says: “If you can afford the luxury of an inflation-linked annuity then that will give you the most security and peace of mind.
"If you have to compromise then buy a fixed increase – say 3 per cent, as this will give you some inflation proofing and is probably better value. If you buy a level annuity you are committing yourself to a falling real income.”
Hedging your bets
He also points out that you don't necessarily have to choose one or the other. “There is nothing to stop you hedging your bets by using some of your pension fund to buy a level annuity and some to buy an inflation-linked annuity.”
Whatever you do, don't just buy the annuity your pension company offers you. You can shop around and often get 25 per cent more income. That's an extra £1,000 per year for every £4,000 of income.
If you use the Confused.com annuity service you could increase your income in retirement by up to 40 per cent depending on your medical situation.
Finally, consider options other than conventional annuities, such as income drawdown or variable annuities. These allow you to take more or less income more flexibly, and you get to keep investing your pot and pass part of it on to your heirs. The major downside is that your income and your pot is not guaranteed and is at risk due to investment risks.
McPhail notes that you can also split your pot between a level annuity and a drawdown but adds "that may be a step too far for many."
