Personal finance: Beware the P-day jitters

Pension rates may be falling - but you can still plan for a happy retirement. By John Burke

IT IS enough to put years on your life. The bad news is that gilt rates, the basis on which pension annuities are calculated, are down to around 5.8 per cent, the lowest for 30 years. They look like slipping further and reducing the pension you can expect from your fund.

This is bad news for anyone in their fifties and sixties and approaching retirement, because a good annuity - an annual income in exchange for all the capital built up in your pension fund - can make all the difference between a happy retirement and ending one's days in poverty.

The amount you get for a set sum of pension capital varies slightly from one provider to another. But all providers use the current yield on a package of UK government stocks to set the level of annuity they will currently offer.

Although short-term interest rates have been rising during the past year, long-term bond yields have been falling in anticipation of the UK joining EMU and adopting a generally lower level of interest rates.

You can choose from a range of different types of annuity.

A "level" annuity pays out exactly the same amount each year until you die. By contrast, "level guaranteed" annuities pay out each year for at least five years even if you die in the meantime, although the guarantee means that the annual payment will be slightly less.

For example a level annuity without guarantee might pay a man of 65 about pounds 928 a year for life, in return for a lump sum of pounds 10,000. With a guarantee the payment would drop to pounds 910. As women live longer than men a woman of 65 would only get about pounds 785 a year. Retiring at the normal age of 60 would only get pounds 710.

A "joint life, last survivor" annuity pays a couple the same amount each year until the second partner has dies. A man of 65 and a woman of 60 would get around pounds 670 a year for a joint-life, last-survivor annuity, or pounds 735 a year if they accept a one third reduction on the death of the male partner. Either way, the annuity will be lower than it would have been on a "single-life" annuity which pays out on just one named individual.

The great disadvantage of a "level" annuity is that it has no protection from inflation.

As a rule of thumb, if you divide the rate of inflation into 70 you will get the number of years it takes to halve the real value of money. So, if inflation averages 4 per cent, as it has done over the last 10 years, a level annuity at the age of 65 would have roughly halved in value by the time the pensioner gets to the age of 82.

An "inflation-linked" annuity increases the annual payment - usually by 3 per cent or 5 per cent each year - to give you some protection against inflation. But in year one it might pay out only pounds 600 on an investment of pounds 10,000 and it would take 12 to 13 years for the escalating pay-out to overtake the level annuity.

One option, especially for people who intend to reduce their workload and income gradually, is to go for a "phased retirement" option - also known as "staggered vesting". Instead of converting the whole pension fund, withdrawals are scheduled over several years.

Another possibility is to shun the conventional flat or stepped annuity in favour of a with-profits annuity, started by Equitable Life in 1987 and subsequently copied by Scottish Widows. The pension proceeds are invested in a with-profits fund and build up annual bonuses which should grow year by year like an escalating annuity.

More of a gamble is the "unitised" annuity - available from companies like Allied Dunbar - for outpacing inflation.

Instead of being put into Government bonds with a safe yield, the fund is turned into units invested in one or more of the world's stockmarkets. Each year, the income from what is effectively a unit trust should bump upwards but it could also fall.

Most daring of all is to go in for an "income draw-down" option. This means deferring the annuity, draw an income from your fund instead and hope that annuity rates will improve later.

The government sets a minimum and a maximum income you can draw down each year, but if yields decline there is a risk that the capital will gradually be depleted. So the hard thing is to know how much to take out when, while leaving enough time and funds for a worthwhile annuity by the age of 75.

Even if annuities decline further on average, buying one at a later age will compensate at least partially. But you will of course have less time left to enjoy it. On a pounds 100,000 lump sum, for example, Prudential is currently quoting a yearly income of pounds 8,237 at the age of 60, but a man of 75 will get pounds 12,844.

Scottish Widows' pensions strategy manager, Ian Naismith, acknowledges: "Whatever the choice, the arithmetic is complex".

Sun Life and Standard Life are also in the top five for drawdown along with the National Mutual. Scottish Mutual does it too, but Prudential confines itself to phased retiral and unit-linked plan. Its marketing manager, Nigel Emery, warns: "These are all sophisticated products compared to traditional annuities, so you must have professional advice".

That was what decided the Annuities Bureau in January to form a separate Income Drawdown Advisory Bureau whose director, Ronald Lymburn, says: "All three variants are riskier than guaranteed products. At least one company can offer `stop-loss' on unit-linked annuities, limiting losses, but you could still be down by 5 per cent compound in bad years."

The options depend on various personal circumstances, ranging from health to wealth. Phased retirement may help to avoid taxes, whilst drawdown (preferably starting at pounds 100,000) could be good for dependants and heirs, although they face a tax-trap.

If you already have enough income from other savings or from still working, then phased retirement should be the best bet. Finally, if you are of the younger generation, a series of personal pensions with separate companies can provide complete flexibility in any event, by giving a choice of different annuity providers to go to with each lump sum.