A joint report by the NAPF and the Pensions Institute (PI) at Cass Business School found half a million people retiring each year are being short-changed by up to £1 billion from their total future pension income, because overwhelming obstacles stop them getting the best deal.
The report also uncovered evidence of sharp practice and murky pricing in the annuity market, putting unsuspecting consumers at a huge disadvantage.
The loss could treble in size to £3 billion over the next decade as the annuity market matures and as up to 8 million people start being automatically enrolled into workplace pensions from 2012.
And 20% of these losses are passed on to the public in the form of lost taxes and higher means-tested retirement benefits.
When they retire, people in the private sector saving in a 'defined contribution' pension - now the most common form of company pension scheme - use their pension pot to buy a product called an annuity from an insurer. This gives them a regular income and is a one-off, irreversible decision that sets the size of their pension for the rest of their life.
The process for choosing an annuity is a complex one and the majority still go for the 'default' option by sticking with their pension scheme provider. This failure to shop around for a better deal can wipe 30% off their annual pension income, and in some cases up to 50%.
The NAPF/PI report found that it is too difficult for savers to get the best deal. It revealed 80% of savers have pots of less than £50,000, and most annuity advisers will not find it profitable enough to advise on pots of this size. So the 'open market option' (OMO) shops where they can find the best products and rates are effectively shut. This will have a real impact on the millions of low to median earners auto-enrolled into a pension.
Fewer than one in five people have the financial know-how needed to pick the right annuity at the best price. The rest lack sufficient understanding of factors like interest rates, inflation and longevity, and need some form of advice.
And those savvy enough to 'shop around' for the best rate struggle to do so because the best shops are not signposted. It is virtually impossible to find a specialist adviser who covers the whole market and who is willing to help those with smaller funds.
Tellingly, it showed people get "too little support" from employers or providers when making a decision about their annuity - often they get nothing more than a leaflet pointing them to a website with a postcode-based search engine.
The report, partly based on extensive interviews with companies that cover 80% of the annuity market, also discovered that annuity prices are heavily manipulated.
There is a severe lack of transparency and understanding about how annuities are priced, especially for those with medical conditions who could qualify for a much higher level of pension income.
Joanne Segars, chief executive of the NAPF, said: "The annuity market desperately needs to be straightened out if the UK is to pay for its old age. People are saving through their working lives only to end up short-changed by a toxic system. Every year a billion pounds that could have been paid out in pensions instead disappears down the plughole of a murky annuity market. Lower and middle income workers are especially vulnerable.
"There is no point in encouraging people to save if we do not help them get the most out of their savings. Too many end up stuck with the wrong annuity at a bad price. Those about to retire need to shop around for a good deal, but how can they do that if the shops are either shut or impossible to find?
"The way the market is priced and structured must become more transparent, and people need stronger support in picking the right annuity. The Government and the industry must work harder to create a clearer, fairer system that delivers better value for money."
David Blake, director of the Pensions Institute at Cass Business School, added: "This report is a wake-up call to the pensions industry, the government and the regulators. If the annuity system is not radically overhauled, employees in defined contribution schemes in the private sector will continue to suffer massive detriment and the government's new auto-enrolment regime will fail the very people it aims to help secure financial independence in retirement."
The report coincides with the deadline for consultation by the Association of British Insurers on an industry code around annuities, which aims to encourage shopping around through promoting the 'open market option' (OMO).
