The worst mistake pensioners make

If you are of retirement age and are about to convert your carefully saved pension pot into a life-stream of income (an annuity), there is a strong chance that you will do so in a pretty straightforward way. You'll look at a few quotes and you'll go with the company that offers you the highest annual income upfront.

You will have done what we usually suggest bought the most simple product on the market and the one that appears to offer the most value too and exactly the same as nine out of ten other annuity purchasers. But you might also have made one of your worst financial mistakes ever.

Why? Because you are probably going to live for another 20-30 years and you've just bought something that isn't protected from the ongoing UK government policy of inflation-creation.

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Let's say you have £500,000 in your pot and decide to buy a single-life level annuity (one that doesn't shift to a partner on your death and doesn't rise with inflation). This should give you an income of around £26,000 a year. Go for an inflation-linked annuity and you'll get rather less say £15,000. Now move on 15 years and assume inflation at 3% a year every year (this is much lower, by the way, than the effective rate pensioners have actually experienced).

The £26,000 is now worth the equivalent of £14,400. Make the rate 5% and it is worth £9,800. The £15,000, on the other hand, has risen every year as inflation has. It is still worth £15,000.

That might work just fine for you perhaps you want to front-load your spending; perhaps you are sure inflation won't rise much above 3% or perhaps you reckon that by getting the £26,000, spending £15,000 and investing the rest you can beat the annuity firms at their own game. But it is worth knowing the numbers either way.

So what might you have done instead? "Optimise rather than maximise", says Josephine Cumbo in the FT. Look at the kind of inflation-linked annuities mentioned above. Take an honest look at your health and if you don't think you'll make it beyond 15 years, look for an enhanced annuity' (these pay out higher rates to those who are likely to die youngish).

Think about an investment-linked annuity which will keep your money invested (and so perhaps protected from inflation) while paying you an income too.

Otherwise, for those with £20,000 of pension income from other sources (public-sector final-salary schemes perhaps), there is flexible drawdown (which allows you to keep your money invested and take it out whenever you fancy). Or for those without the £20,000, a capped drawdown leaves it invested but allows more limited withdrawals.

Finally, if you are remotely fond of your partner and they don't have a pension income of their own, you should consider a joint annuity so that should you die before them, they continue to receive an income.