A lot of little pensions...one big question

Chiara Cavaglieri and Julian Knight on how job-hoppers can rearrange the deckchairs if they have funds that won't buy an annuity

Many of us will have two or three careers during our working lives, and that could mean we head into retirement with a number of different pensions, both workplace and personal. This has the advantage of diversification – of spreading our investment risk. But there are also downsides, particularly in terms of converting these retirement funds into an annuity – the income for life we must all have taken out by the age of 75.

"The problem is that many insurance companies won't offer annuities to people with less than £10,000 in a pension pot," says Tom McPhail, head of pensions research at independent financial adviser (IFA) Hargreaves Lansdown. The answer, he adds, could be to combine all the little pensions as this will make it easier to buy an annuity. "Once it's over the magic £10,000 figure, the choice suddenly becomes very wide indeed. What's more, it will make the administration leading up to retirement much easier."

The disadvantage with consolidation is that you may have to trawl through some paperwork to combine all your pots into one, and penalties could be imposed by insurers for moving your money. "These are getting more unusual but on pensions taken out 10 or so years ago, there may be exit penalties of as high as 15 per cent. In such instances think very carefully before combining," adds Mr McPhail.

Another option is to take the pensions as individual lump sums. Since changes to pensions legislation introduced in April 2006, smaller funds that total less than 1 per cent of the standard lifetime allowance (which for 2008-09 is £1.65m) can be taken as cash. So anyone retiring now with a pension pot worth less than £16,500 can withdraw their money in this way, with 25 per cent tax-free and 75 per cent liable for income tax. In April, the start of the next financial year, the limit will rise to £17,500.

But it may well be that even those who are eligible for these lump sums will actually be better off taking out an annuity. "With interest rates at an all-time low, the interest earned on an individual savings account, say, would be minimal," says Joe Hill, director at IFA the Independent Life & Pensions Group. By contrast, he adds, "a male aged 65 can get an annuity rate of 6.6 to 7 per cent at present". This compares to an average return on a high-street savings account of around 1 per cent.

Remember, there is no obligation to buy an annuity from the same company that holds your pension. Indeed, your existing pension provider is unlikely to offer you the most competitive rates, so it is essential to scour the market for the best deal.

In addition, there are several factors that affect annuity returns, including medical conditions, where you live and your marital status. Smokers or diabetics, for example, may be eligible for "impaired life" annuities, which offer better rates because of the shorter life expectancy. Again the message from financial experts is to shop around for a policy.

But be warned: annuity rates are on the slide. According to financial analyst Moneyfacts, the average annual annuity income paid on a £10,000 pension pot has dropped from £638 to £597 in the past four months alone, and this is likely to get worse, at least in the short term. The main problem is the lower interest rates being paid by the Government on its bonds, which make up a key investment for insurers offering annuities. If low interest rates persist, the pay rate on annuities is likely to fall much further over the coming years.

One option for those worried about low rates is to pick a short-term annuity that lasts for five years, as opposed to the rest of the applicant's life. This approach will allow retirees to review their policy further down the line in the hope that they will be able to ride out the poor rates. "If in five years' time interest rates and gilt yields are higher than now, then combined with their higher age, this should enable people to lock into a higher rate," says Alistair Mellor, director at IFA the Financial Management Group.

However, this too is not without significant risk, and there is no guarantee that returns won't just drop further. "With ever-improving mortality rates," adds Mr Mellor, "annuity rates could be even lower than they are now."