Personal Finance: The sun goes down on savings

The combination of longer life expectancy and lower interest rates may come to mean misery for millions, warns Isabel Berwick

WE MAY be relatively prosperous now, but millions of Britons face a long retirement on a meagre income. The problem is simple: we are living longer but are not saving enough for a retirement that can be almost as long as our working life.

A woman who celebrates her 40th birthday this year can expect to live another 44 years, on average. A 60-year-old in 1998 can expect another 20 years. Men of 40 have a projected 40 years to go, and at 60 they also have 20. In 1998, 7.3 per cent of the UK population is 75 and over. By 2036 almost 12 per cent of the population will be 75 plus - including many people reading this article.

Simon Conder is marketing manager for a firm of pensions specialists, Teather & Greenwood. He's in his 30s and he's worried.

"A man who retired in the 1960s could expect to be dead eight years later. I'm working hard to retire at 54. I'm fit and I could be retired for 40 years. The thing that frightens me is where am I going to get 40 years' worth of retirement income from?"

But Mr Conder's problem, and that of millions of others, is not just longevity. It is that long life has combined with falling interest rates to produce a disastrous situation.

At retirement anyone with a personal pension or a company scheme that operates on a money purchase basis will have a large pot of money that has usually been invested on the stock market. Most people call this a "pension" but it's a misnomer. Most British people have to secure their retirement income by swapping most of the pot of cash for a contract to provide a guaranteed annual income. This is called an annuity, and it has to be very safe, so the big life insurers pay for the annuities they sell by buying fixed-interest investments, mainly government bonds called gilts.

The drawback is that the current low-interest rate climate means your money buys you 32 per cent less income than it did four years ago. You get tax breaks when you save for retirement, but not when you take the proceeds. A married, higher-rate taxpayer who wanted to make sure his or her income would rise by 5 per cent a year in retirement would typically be offered an income of just pounds 4,710 a year for every pounds 100,000 in the pension fund. That's bad enough, but if you die after making a deal to buy an annuity, the insurance company keeps everything you have handed over.

So a retiring man might want to arrange for his wife to carry on getting some income after his death. A widow's pension would be worth just 50 per cent of the full annuity rate - which, with this guarantee and a 5 per cent rise each year, is now pounds 3,297 a year for each pounds 100,000 invested.

"We come across this problem all the time," says Julie Sebastianelli, manager in the personal financial planning department at the accountants Arthur Andersen. "Even if interest rates were to go up, it takes a long time to impact on long-dated gilts. This is probably a very long-term problem and if EMU happens, the convergence will mean low interest rates, low annuity rates and depression all round."

You might think the Government would step in to help people faced with such a catastrophic return. But instead, ministers are compounding the problem by making the new "second-tier" pension scheme work in exactly the same way as a money-purchase scheme. You build up a fund in your stakeholder pension (leaks suggest contributions are likely to be compulsory for many workers) and then swap it for an annuity at retirement.

What you can do

There are ways round the annuity problem. If you are over 40, the best solution is to get a job with a pension scheme which guarantees you a certain level of pension income, usually two-thirds of your final salary, if you have worked for 20 years for the same company. You can buy "added years" of service if you join a scheme later in life. Many firms' schemes have shut to new entrants over the last few years. Unless you plan a career in the public sector, you should expect to face the annuity problem when you retire.

If you are coming up to retirement within the next few years, start thinking about options other than a conventional annuity.

"To be honest, the only solution to this is to take more risk to get an adequate income," says Andy Frepp, head of marketing at Scottish Widows.

Mr Frepp believes that with-profits annuities are a useful solution. You hand over your money in the same way as you do for a conventional annuity but the life insurer pays you an income based on the performance of its with-profits fund, containing shares and fixed-interest investments. The income is not guaranteed but is based on current bonus rates paid by the fund.

Mr Frepp says: "The current bonus is 7 per cent and, assuming it stays at 7 per cent, your income rises 7 per cent during the year. It can also come down again, but smoothly."

Another choice is to link your income to the stock market through a unit- linked annuity. This is for those who don't rely on their pension as the sole source of income.

"With a unit-linked annuity you buy into whatever fund or funds you attach the annuity to," Mr Frepp says. "It may be a fund buying UK shares, and over the long term it will out-perform the yield on gilts. But your income from month to month depends on how the fund performs."

Those with a much larger retirement fund can opt to leave most of their pension fund invested and live off some income. This is called income drawdown. Mr Conder, at Teather & Greenwood, says: "The ideal income drawdown client has a fund of around pounds 200,000 plus and no mortgage, plus an extra pounds 200,000 investment capital in shares, PEPs and other investments."

Younger people have more choices. Ms Sebastianelli says: "The answer is either to increase pension contributions or diversify into other investments. In your 30s, don't over commit to pensions, you won't be able to draw the money for at least 20 years. Have some free assets as well."

For most of us, that means putting cash into PEPs and the new ISAs from next year. And hoping that we are doing enough to secure a decent income for our retirement.

Retirement contacts: Chartwell Investment Management has an excellent free guide to retirement options. Call 01225 321700.

Annuity/retirement specialist advisers: Bridgegate Annuities, 01244 401991; Teather & Greenwood, 0171- 426 9000; The Annuity Bureau, 0171- 620 4090.

the American way

Some campaigners are calling for retired people to be able to leave their money invested and manage their funds themselves, as they do in the US. This would avoid the problem of falling interest rates but would leave many more people vulnerable to volatile stock markets.

In the US, workers and their employers make contributions to a tax-deferred retirement fund (called a 401(k) in the private sector). Most public and private schemes offer similar benefits, and employees and employer make contributions up to defined limits. Workers can choose how their funds are invested and running costs are very low.

At retirement the accumulated cash from company schemes is moved to an individual retirement account (IRA). Most of the money is invested (usually on the stock market) and the retired person takes an income.

Americans also get a social security pension, based on income and contributions. Workers pay 6.2 per cent of their salary (up to $68,400) towards the scheme.