The theory behind a pension is simple. You save like a madman during your working life, build up a pot of cash, then use it to buy an annuity (an income for life) to see you through your old age.
Hopefully your pension pot will be a decent size and you will get the best possible deal for that annuity after such a long, hard graft – right? Sadly, in many cases, that is not the case.
Insurers are obliged by law to make it clear that, even though you may have held your pension savings with one particular firm for many years, you have the right to go elsewhere when it comes to investing your final pot. But some firms seem loath to see all that money going to a competitor, according to a report issued last week by the City regulator, the Financial Services Authority (FSA).
The right to take a pension pot and use it to buy an annuity from any provider is known as the open market option (OMO). But too often, says the FSA, insurers bury important information regarding the OMO deep in the small print.
As a result, the independent financial adviser (IFA) Hargreaves Lansdown has estimated that two-thirds of pension holders are not exercising their OMO and so are being automatically shunted on to their existing pension provider's own annuity rate, which is unlikely to be the best deal available.
The FSA has found that an alarming 40 per cent of literature sent to pension savers by insurance companies does not comply with the law. Sarah Wilson, the director responsible for the FSA's Treating Customers Fairly initiative, says: "We have found a gap of around 20 per cent between the top and bottom annuity rates. There is significant potential for customers to achieve higher incomes."
Securing the best deal is particularly important for people with a reduced life expectancy – smokers, for example, or those with a medical condition such as heart disease. Through the OMO, they should be able to find a higher than average annuity rate, since insurers can expect to be paying out for a relatively short time. But by allowing themselves to be shunted on to the default annuity, they are often not getting the chance to do this.
"Insurance companies make a nice profit out of selling people their default annuities," says Tom McPhail, head of pension research at Hargreaves Lansdown. "There is no reason why they should not be forced to send customers simple, clear and brief information on their choices."
But even without such information, savers can still take matters into their own hands. "Shopping around for the best annuity deal is not difficult," says Malcolm McLean of The Pensions Advisory Service (TPAS), a not-for-profit organisation that has recently launched an online annuity comparison tool (see www.pensionsadvisoryservice.org. uk). "It is more a case of being aware of your options. People need to understand that there are a number of different annuities out there, including ones that will continue to pay out after death to a spouse."
It is also possible to buy a short-term annuity – of less than 10 years – if you believe rates will improve later. However, once you have gone down this route, you must by the age of 75 have bought an annuity to cover the rest of your life.
But savers should note they are not obliged to buy an annuity. You can "draw down" an income from your pension pot through an alternatively secured pension (ASP) from the age of 75. The money is placed into an ASP fund, which is available for you to use as you wish every year up to a maximum amount determined by the government. You don't have to draw from it if you don't need to, and you can stop the ASP at any time and buy an annuity.