Annuities still the best choice at 75

MOST retirees yet to buy an annuity must still do so when they turn 75, after the government rejected calls to end compulsory annuitisation.

With volatile markets decimating pension fund values, the government came under pressure to raise the age of compulsory annuitisation to 80 or abandon it altogether. But changes were ruled out, with the government concerned about the potential for those on income drawdown to run out of money and be forced to rely solely on state benefits.

Tom McPhail, head of pensions research at Hargreaves Lansdown, said this is a valid issue, but one with a simple resolution: mandatory annuitisation at 75 up to a certain income. "This would guarantee that pensioners will not have to go cap in hand to the state," he said. "The remaining fund above this level could then, in good conscience, be used at the discretion of the investor."

In the meantime, those who have not bought an annuity by the time they reach 75 have to do so, or transfer to an alternatively secured pension (ASP) – a way of continuing drawdown but an unsuitable choice for most people. Here's how those options compare:

Annuities

These offer a stable, guaranteed income in retirement and are bought by the vast majority of people at retirement, although products combining annuities and drawdown have emerged in the past two years.

Annuity rates have been at six-year highs in recent months, but steep interest rate cuts mean they are likely to tumble over the next year.

Annuity pricing is based on gilt and bond yields, which fall when interest rates drop. A fall of 10 per cent in annuity rates would leave a 65-year old man with a £100,000 pension pot £15,000 worse off in retirement. Consequently, many people are either locking into the current high rates or seeking alternatives to conventional annuities.

One option at 75 for those who want some form of stock market exposure is an investment-linked annuity, which is linked either to a unit-linked or with-profits fund.

But while this offers the promise of higher income than from a conventional annuity, the opposite could also happen as they are linked to the performance of the underlying fund. Although conventional annuity rates are declining, there's still a gap of around 20 per cent between the best and the worst available.

This makes it essential to shop around for the best rate available, using the Open Market Option.

Many retirees are unaware that they can do this and opt instead to stay with their existing pension provider, often to their detriment.

There is also low awareness around enhanced or impaired annuities.

These pay out a higher income to people who smoke or suffer from ill-health, on the premise that the payout period will be shorter.

Alternatively secured pensions

An ASP offers income of between 55 and 90 per cent of GAD (government actuary's department) annuity rates on your 75th birthday, whereas income drawdown (used as an alternative to annuities before 75) allows up to 120 per cent to be taken.

This compares poorly with annuities, said Gordon Simpson, senior consultant at Punter Southall in Edinburgh. "In income stream terms, annuities are more effective at 75 and are guaranteed. Only if income is not a priority would you consider continuing drawdown after 75."

The advantage of ASP is that surplus funds can go to your dependants when you die (in the form of income rather than a lump cash sum).

However, the dependants must be a surviving spouse or partner and any children under 23 who are in full-time education, a stipulation that rules out most grown-up children.

Payments on death that fail to meet these criteria are subject to a punitive tax charge of up to 82 per cent, making ASP a no-go zone for the vast majority of investors.

"ASP is suitable only if your main concern is capital control and passing a sum on to your estate, even if there is a massive tax charge on it," said Simpson.

There are ways of minimising the tax take, however. For instance, if you take your maximum tax-free lump sum of 25 per cent of the pension fund early in retirement that money can be put into an IHT- efficient trust, provided you survive for seven years after making the gift.

"You could also consider taking out as much money out when you can," said Rachel Vahey, head of pension development at Aegon.

"Direct, regular payments of your ASP income to your dependants or grandchildren are tax-efficient."

But with an average retirement pot of £25,000 in the UK, according to the most recent data from the Association of British Insurers, an ASP is out of bounds for the vast majority of pensioners.

"You would need to have a robust financial position with a pension pot of £100,000 at the very least, or a very substantial and secure alternative source of income to take equity market risks after 75. If not, it isn't an option, " said McPhail.

If you are contemplating an alternative to a conventional annuity at 75, you should speak to an independent financial adviser, preferably one with qualifications relating to pensions.