In 2007 alone, 400,000 people entered retirement. So investors who are considering what to do with their pensions savings are not alone.

However, the choices facing investors are becoming ever more complex. This process is driven partly by legislative changes, partly by the investment environment, and partly by demographics.

So what are the options available? There are two main ways of converting your pension pot into income – buying an annuity or using income drawdown.

Coping with annuities
Until the mid 1990s, the only real choice for anyone with a maturing pension plan that wasn’t a final salary (probably occupational) scheme, was to buy an annuity. Annuities came in differing shapes and sizes – single or joint life, with or without inflation proofing, and perhaps including the option of a guaranteed payment period. But they were never what you would call ‘exciting’.

However, I do think the ordinary annuity is a much better product than many give it credit for. It does one thing very well, and that is that it guarantees you an income for the rest of your life, no matter how long that is.

Nothing else does this. Such a guarantee leaves you with more flexibility to manage the rest of your money creatively, secure in the knowledge that your annuity will keep paying out.

However, an absolute golden rule for retiring investors is to shop around to ensure that they get the highest annuity rate available at the time. This can easily be done by using web-based annuity comparison sites or by seeing an IFA. This is a process that may only take a few minutes, but could mean that investors enjoy thousands of pounds more in terms of income in retirement.

Such ‘shopping around’ is important because buying an annuity is a one-off decision. Once an annuity has been bought, you can’t change your mind and swap providers at a later date. So get it wrong and it could prove to be a very expensive oversight.

Mixed outlook
Looking ahead, there is a mixed outlook for annuities. On one hand, interest rates are at historically low levels and, as a result, annuities have looked pretty poor value compared to the high payouts of yesteryear. A rate of 7.5 per cent looks much less attractive than 14 per cent. However, set against that is the possibility that there are real inflation fears for 2008 for the UK, and that could push yields and annuity rates up.
The other factor to consider is that we are all living much longer and insurers have lowered rates to reflect this. Life expectancy at age 65 has risen at a rate of three months a year over 25 years, adding several years on to the average annuity payment period. This is set to continue, with a corresponding knock-on effect to annuity rates.

Risks of income drawdown
With drawdown, you have control over where your money is invested, and how much income you can withdraw. You also get much more attractive death benefits than is the case with an annuity.

But there is still a link to the annuity market. Since 2006, the maximum income you can take from a drawdown plan is 120 per cent of whatever an annuity will pay, while the minimum is zero.

This may not seem like an overly generous means of accessing your own pension fund but, in effect, it means that it is now possible to strip money out of your pension fund at what will probably be an unsustainable rate. A 65-year-old man could draw an income of around nine per cent per annum. Factor in some charges and you are looking at a required investment return of perhaps 11 per cent or more per year just to maintain this level of income. So if you want to empty the pot, it may take a few years, but you will almost certainly be able to do it.

Conversely, you can just take your tax-free lump sum of 25 per cent of your pension savings and defer drawing any income. This option is becoming increasingly popular. Investors can withdraw their tax-free lump sum at age 50 (55 from 2010), and leave the balance of their pension fund invested and growing until they need to draw on it, perhaps ten or 15 years later.

Death benefits for drawdown plans are a definite attraction, compared to the relatively inflexible terms of an annuity.  Nothing needs to be decided in advance. On your death, your spouse has the choice to carry on with the drawdown plan as if it were their own; take the entire fund and buy an annuity for themselves; or take the fund value as cash, less a 35 per cent tax charge.

Future retirement strategies
Over the past year, we have seen a growing trend towards annuity market segmentation, based on expectations of life expectancy. Put simply, the less time you are likely to be receiving income from your annuity, the higher the level of income you will get.

Insurers are launching variations on this theme, such as separate smoker and non-smoker rates or underwritten rates, where they look for evidence of compromised health and life expectancy. We have even seen postcode rates, on the basis that people in Kensington do, on average, live around 11 years longer than the inhabitants of Glasgow, for example.

By contrast, if you are healthy and wealthy, then you are going to be increasingly disinclined to purchase a conventional annuity at age 65. Put crudely, you may be better off waiting until your mid seventies, when your health starts to deteriorate, and you may secure a better rate. Until then, you may choose to stay invested in a drawdown plan, managing your investments.

Variable annuities
The big thing in 2007 was variable annuities, which are broadly a hybrid of drawdown and a conventional annuity. They offer investment market exposure, with the potential benefit of further growth, some death benefits and the certainty of guarantees on the level of income paid out.

This looks like an attractive package and, in principle, they are a good idea. Unfortunately, the products that have actually seen the light of day to date have struggled to overcome cost issues that can have charges pushing up towards four per cent a year.

The consequence of this is that if an investor was drawing five per cent income from their pension fund, they would be requiring an investment return of up to nine per cent per annum just to stand still.

Future market developments
In any case, under current rules, the government requires investors to buy an annuity by the age of 75, thereby putting a time limit on these combined post-retirement investment strategies. There are a couple of ways around this problem, involving some continued control over your investments but with less flexibility over the income withdrawals and with much tighter death benefits.

There will be continued product innovation. The ‘at-retirement’ market is already worth around £12 billion a year and it will grow fast from here.

There is one universal truth in all of this. Whatever the size of your pension fund, the one thing you absolutely must do in the run-up to retirement is think hard about what kind of income you will want, and make sure you shop around for the right solution.

Nigel Callaghan is a pensions analyst with Hargreaves Lansdown