Gambling With Your Life

When you come to retire, you face the biggest bet of all...

Saving for retirement is one of the most important financial decisions we make. Alas, for many of us, it's also one of the most boring activities!

Building a pension pot

If you're very fortunate, then your employer will ease your pension problems for you. As a member of a final-salary pension scheme, your company pension will be based on your years of service and salary at retirement.

In other words, your employer takes all the investment risks, while giving you a guaranteed payout at, say, age 65. Unfortunately, final-salary pension schemes are now increasingly rare outside of the public sector, as companies close these schemes to stem their steep running costs.

Hence, most workplace-based pensions are money-purchase (alias defined-contribution) schemes. Payouts from these plans depend on three factors:

1. how much you and your employer contribute;

2. how long you pay in; and

3. the investment gains your pot makes during this period.

The gamble of your life

Once you've sacrificed your income to build up a big pot of capital, then you need to turn this fund back into income when you retire. At this point, you face the biggest gamble of your life.

You could take some risk by opting for 'income drawdown' or 'flexible drawdown'. With income drawdown, you leave your pension pot invested, but draw a taxable income from it. In other words, you continue to manage your fund and make all investment decisions. Get it right and your income and capital could continue to grow. Get it wrong and you could drain your fund.

Anyone aged 55 or above is eligible for income drawdown. The amount of income you can withdraw will be between zero and a maximum capped income (which is based on mortality tables and government bond yields).

Some investors can remove this income cap by applying for flexible drawdown. This allows you to draw as much income as you like, when you like. However, you can only enter flexible drawdown if you already have a secure pension income of £20,000+ a year.

Annuities: the safer option

Of course, drawdown is a high-risk strategy that could, in the worst-case scenario, deplete your pension fund. Hence, most retired people decide to go for the safer option. This is an annuity: a guaranteed income for life paid to you by an insurance company.

However, there is a steep price to pay for buying an annuity. In return for this guaranteed lifetime income, you have to surrender your pension pot to an insurer. Regardless of how long you live, the insurer keeps your pot when you die.

In other words, buying an annuity is a simple gamble on how long you live.

If, like Frenchwoman Jeanne Calment, you live to be 122, then you've beaten the system. Then again, if you die, say, a year after retirement, then you've lost this bet (even if you've opted for a minimum payout guarantee of, say, five years).

Annuity rates tumble

The second big problem with annuities is that annuity rates vary widely from one company to another, and they change significantly over time.

For instance, 15 years ago, a £10,000 pension pot would buy a level annuity worth roughly £1,000 a year for a 60-year-old man. Today, the same pot would produce under £580 a year. Annuity rates have been forced down by a combination of increasing longevity and falling gilt yields (the income paid by UK government bonds).

Annuities are individually tailored, so how much you receive will depend on your age, gender (but only until December 2012), your general health and whether you smoke. Also, your income will vary according to whether you choose a single-life or joint-life annuity, and whether you opt for a level, rising or inflation-linked annuity.

Three ways to beat the odds

When you take the annuity gamble, you're up against an insurance company and its professional statisticians, known as actuaries. They weight the odds in the insurer's favour, such that annuities are a pretty profitable business for the likes of Aviva (LSE: AV), Prudential (LSE: PRU) and Legal & General (LSE: LGEN).

However, here are three ways to tilt these odds slightly in your favour:

1. OMO: your right to shop around

First of all, you don't have to buy your annuity from your pension provider. In fact, your Open Market Option (OMO) gives you the right to buy an annuity from any UK-authorised insurer.

Thanks to the rise of the Internet, shopping around for the highest annuity rates has become much simpler. Indeed, annuity brokers such as Hargreaves Lansdown, Just Annuities and the Annuity Bureau will do all the legwork for you.

2. Buy an enhanced annuity

Medical problems or poor lifestyle habits (such as smoking and drinking to excess) will shorten your lifespan. Hence, people suffering from diabetes, high blood pressure, obesity and similar problems can buy what are known as enhanced or impaired annuities.

These pay out higher incomes to those people likely to have a shorter retirement. Again, the best way to find an enhanced or impaired annuity is via a specialist annuity broker.

3. Take your tax-free cash

Lastly, you're not obliged to turn all of your pension pot into an annuity. In actual fact, you can withdraw up to a quarter (25%) of your entire fund as tax-free cash. You can then invest this cash to produce future income, perhaps inside a tax-free ISA (Individual Savings Account).

Alternatively, if this lump sum is more than, say, £20,000, then you could use it to buy a purchased life annuity (PLA). Payout rates for PLAs tend to be lower than for compulsory purchase annuities (those bought using pension pots) -- typically 80% to 90% of the pension payout.

However, the taxman recognises part of the payout from a PLA to be a return of capital. Thus, much of the income from a PLA is tax-free, as 5% of the pot is treated as a yearly return of capital.

Finally, whatever your plans are for retirement, it makes sense to plan ahead and perhaps take professional advice for some of the more complicated aspects. Otherwise, you could lose the biggest gamble of your life!

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