Don't let your pension provider leave you penniless

published 26 October 2010

I want to deal with a very serious subject today. If you're approaching retirement, I urge you to take note.

Even if you're not ready to put your feet up just yet, if you've got a personal pension, you ought to beware of some nasty legislation that affects you.

Here's what concerns me - I think that over the next decade we could witness a very bloody episode for pensions. In the coming years, some retirees could see their savings slashed as events conspire against them.

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So today I want to show you how you can avoid getting wiped out. It's only general information - you should always take financial advice before making radical changes to your pension planning.

But I really do believe there is grave cause for concern for anyone with a pension in this country. Here's why.

The legislation that could leave you broke

Current legislation says that between the age of 55 and 77, you've got to cash in your personal pension fund and buy an annuity.

An annuity is an insurance policy that provides you with a specific income until you die. Different policies are available; for instance, you may want to leave an income to your spouse. But the general idea is that it's an income for life. Die early and you'll get a particularly raw deal.

The insurance company (annuity provider) calculates how long they reckon you'll live and how much money they can earn from your savings - which they're going to turn into an income for life.

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The problem is that the industry has made a complete hash of these calculations in the past. They hadn't figured on people living longer. And worse, they hadn't figured that the markets could ever go down.

If this wasn't such a serious matter, it would be almost comical.

To make up for past mistakes, the insurance funds are now ultra-cautious. They're not giving anything away.

According to financial advisers William Burrows, annuity rates have fallen from around 16% in 1990 to just over 6% today. That's a disaster for people in the market for an annuity today.

A paltry payback

The annuity best-buy tables say that a man of 60 can expect to receive around 6% a year on his fund for the rest of his life. In the light of bond yields, that doesn't sound too bad does it?

But there is grave danger here.

For starters, remember that after your death, they're going to keep your capital. So, this 6% isn't really interest, it's your interest and capital. But there's a bigger problem: that 6% isn't linked to inflation.

Remember, this is supposed to be an income for the rest of your life. That could be 30 or 40 years. If we get a bout of inflation - and heaven knows the Bank of England may be setting the foundations for it - then you could get wiped out.

Say you diligently saved up £500k and bought your annuity. 6% pays £30k per annum.Sounds alright? But here's what inflation does. If inflation stays around 3%, after ten years your income feels more like £22k a year. Not a disaster. But remember that's if inflation remains subdued.

If inflation goes up to, say, 6% - after ten years you're down to about £16k. And that's just after ten years! I'm not going to frighten you by taking an example with a 'shocking' rate of inflation. By all means, you do the maths using a Seventies-style 20% inflation rate. See how long it takes before you're wiped out!

So, I hear you cry. Can't I buy some inflation protection on this annuity policy? Yes you can - here's what it'll cost you. To get a 5% annual uplift you'll have to halve your income to 3%. That's right. You're down to £15k per annum on your £500k. And this doesn't even protect you if inflation heads over 5%!

A decent bout of inflation will make mincemeat out of annuity holders.

The insurance companies, on the other hand, end up the winners. They invest in bonds, equities and property. Their portfolios are built to get a decent return - with inflation protection.

So if inflation makes a comeback, they'll do pretty well. Their income should go up, while their costs (annuity holders) diminish.

The legislation may well change - so hold fire

The new government knows that there are problems with the annuity legislation. They've already raised the age that you have to take out the policy from 75 to 77.

There is talk that they'll do away with the obligation altogether. If, like me, you reckon there's a good chance that inflation will make a comeback sometime in the next decade or so, I'd hold off buying an annuity for as long as you can.

On Wednesday, I'll run through some figures and show you why I think the annuity providers should be giving a much better rate than they're offering.

And I'll show you what I think is a much better way of getting a decent income that's likely to keep up with inflation at the same time.

This article was first published on 25th October in the free investment email The Right side. Sign up to TheRightSide here.

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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.

He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.

Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.