Why delaying that annuity doesn't pay off any more

Those who've delayed taking out an annuity, in the hope that last week's first rise in interest rates in four years would boost their income in retirement, are in for a big disappointment. Historically, annuity rates have been closely linked to long-term gilt yields which, in turn, reflect changes in interest rates.

When interest rates rise, gilt prices usually fall, which then boosts their yields. But, although annuity providers still invest customers' money in gilts and bonds, changes in gilt yields are having less impact on rates as longer life expectancy becomes increaseingly important.

An added factor is that there is far less consistency in the way they respond to changes in gilt yields. More and more are focusing on particular sectors of the market, which influences the rates they set.

As a result, though the 15-year gilt yield rose to 5.02% earlier this week, this is not being reflected in the annuity rates. The income that a 65-year-old male with a pension pot of £100,000 would now get from a standard annuity with Friends Provident, has dropped from £7,884 in January when the gilt yield was only 4.54% to £7,327.

So, anyone planning to delay buying an annuity should think again for, according to Peter Quinton managing director of specialist adviser The Annuity Bureau, there's little chance of a return to the high income levels of the 1990s as longevity surges.

If you've enough alternative income, in the meantime you could, in theory, gain by delaying as the older you are, the more income you should get based on the assumption of a reduction in your life expectancy. There's also the possibility that, depending on how the stock market performs, your pension pot could increase to further boost your eventual annuity.

If a 65-year-old with £100,000 delayed his annuity purchase by three years and his pension fund grows at a 5% compound annual rate of return, net of charges, it would then be worth £115,763.

Assuming annuity rates don't change, but he gets a better rate as he is now 68, the annual pension income would be £9,706. That's £1,535 more than the £7,671 he'd have received at 65.

That may seem good on paper, but in the meantime he'll have foregone those three years of income totalling £23,013 that he'd have got had he taken his annuity when he was 65. And The Annuity Bureau calculates it would take him over 11 years to make up for that loss.

Even these calculations assume that annuity rates don't fall further and that his pension pot does, indeed, grow by 5%. So, unless you're prepared to take a gamble that the risk is worth the "possible" reward, you'd be better off not delaying taking out an annuity. And if you don't need the income immediately, you could reinvest it.

Whenever you do decide to draw an annuity, it's essential to shop around - once you've made the decision, it's then irreversible. On average, you can improve your income by as much as 10 to 15%. An impaired or enhanced annuity can boost it by up to 30%.

In the past, most people have been unaware of their entitlement to shop around. But just over a year ago the Financial Services Authority introduced new regulations which require companies to alert pension customers to the "open market option".

Even so, recent figures by the Association of British Insurers, show the number of annuities bought on the open market has fallen since the new rules were introduced from 38.2% in the third quarter of last year to 31.2% in the second quarter of this year.

But FSA figures to be published next week show that while more people are sticking with their pension company, many more are using the OMO to check out the best deal - an increase from 48% in March-May last year, to 59% during February to April this year.

The FSA argues that the apparent disparity between its research and the ABI figures is that though more people are shopping around, some are still sticking with their pension provider.

This may be because they offer the best deal, or other providers may not offer the type of annuity they want. Those with small pension pots will have little choice, anyway, as few providers will offer them an annuity.

Given that two-thirds of purchasers have pension pots of less than £20,000 and 43% have funds of less than £10,000, this affects a lot of retirees. Encouraging though the FSA research may be, specialists still believe the regulator should provide clearer guidance as to how life companies alert their customers to the OMO. Some send copies of the FSA's factsheet, others simply bury it in small print. The Annuity Bureau wants a simple standard format and the comparative tables on the FSA website to cover all options.