Shop around for annuities when you retire

"Hugely unfair and opaque" is how the National Association of Pension Funds (NAPF) describes the annuity market in its latest report (written with Cass Business School). We agree. So what's the biggest problem with annuities, and how can you avoid it?

Annuities are the government's way of trying to ensure we don't all fritter away our pension pots when we retire. If you still enjoy a final salary (or "defined benefit") pension, then annuities are irrelevant, as your pension income is already specified.

But for anyone in a private-sector money purchase (or "defined contribution") plan, the rules say you can take 25% of your pension pot on retirement (from age 55 onwards) as a tax-free lump sum. The majority of people will eventually have to use the rest to buy an income stream ("annuity"). It's here that the problems start.

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Annuity rates (a percentage that dictates the annual income you can buy in exchange for your pension pot) fluctuate wildly, differ sharply between providers, and right now, are very low.

For example, according to Thisismoney.co.uk, £100,000 buys a 60-year-old man £3,596 a year (at best) if he wants a 3% annual income escalation (to help offset inflation) and a five-year payment guarantee should he die early. That's not going to fund much of a retirement.

And 80% of us won't even have as much as £100,000 to hand over, says NAPF. Rates are so poor due partly to low bond yields, but also because the big insurers that set the rates have the market sewn up.

Worse, over 85% of us buy our annuity from the same firm that we saved with. No wonder half a million of us get stuffed to the tune of an estimated £1bn a year, says NAPF. Chief executive Joanne Segars concludes savers are being "short-changed by a toxic system". But what can you do?

If you are about to retire, shop around. NAPF estimates that not doing so could cost you 30%-50% of your retirement income. This is known as the "open market option".

Unfortunately, it is "virtually impossible" to get advice on the whole market from one source. So you'll have to do your own legwork most brokers will only quote the best rate from a handful of providers and compare rates from different sites.

If you are some way off retirement, consider using your full individual savings account (Isa) allowance (£10,680 a year) before investing in a pension. The tax breaks are decent and they are far more flexible.