Plan a smoother retirement

Life doesn't get any easier for pension investors. Annuity rates, which rise and fall in line with gilt yields, are currently at depths not plumbed since the 1960s, and conventional plans lock you into the prevailing rate at the time when you retire. The alternative, an investment-linked annuity, pays an income that varies with the returns generated by the investment to which it is linked - but who wants to depend on investment returns for pension income in the current economic environment?

There may be another solution. With-profits annuities are a halfway house between the security offered by the guaranteed - albeit low - income paid by a conventional annuity and the risk profile of a fully-fledged investment-linked contract. The pension income that investors receive each year varies in line with the returns achieved by their insurers' with-profits funds (see box below). These funds invest in a mix of equities, bonds and property, but insurers smooth out volatility over an extended period. That makes for less income insecurity.



Not that with-profits has the best reputation as an investment approach. Not only do the majority of homeowners caught out by the endowment mortgage crisis have with-profits plans, but after two years of stock market losses, insurers are also cutting with-profits fund bonus rates.

Nevertheless, independent financial advisers who specialise in pension planning say the with-profits approach continues to make sense for investors who can afford some exposure to risk in retirement. With-profits fund bonuses averaged between 7 and 8 per cent this year, well in advance of the highest anticipated bonus rates set by investors.

Stuart Bayliss, managing director of Annuities Direct, says: 'People must face up to the fact that the choices they have to make remain the same, but that the values attached to those choices have fallen.' In other words, with-profits annuities are unlikely to produce the increases in pension income that might have been possible 10 years ago, but conventional annuity rates have also become a less attractive deal.

Peter Quinton, managing director of The Annuity Bureau agrees: 'For those who are prepared to accept equity exposure with smoothed volatility, these products are definitely worth considering.'

Certainly there is a risk inherent in with-profits annuities - if bonus rates continue to fall, so will your pension income - but Quinton believes they offer a decent long-term alternative to conventional arrangements.

That said, Quinton also says that with-profits annuity providers need to become more open about the charging structures of their with-profits funds. He adds: 'We want investment-linked annuities to be transferable between different providers.'



Under current Inland Revenue rules it is possible to switch from a with-profits plan to a conventional annuity with the same insurer. Most insurers also allow you to change your anticipated bonus rate - but you cannot move to a different provider. Quinton thinks this is unfair given that an insurer's investment approach - and its returns - may change significantly over the term of your annuity. That could be 25 years or more if your retire at age 60.

However, under the current system, investors have no choice but to pick their with-profits annuity provider on the basis of the best deal available today, in the knowledge that they will be stuck with this insurer should its returns disappoint. Partly, this will depend on the rates on offer - these will vary from insurer to insurer, even if you quote the same anticipated bonus rate each time.

'We're very interested in the free asset ratios of insurers when we pick providers,' says Quinton. This ratio indicates an insurer's financial strength; in general, the more secure the provider, the greater its ability to smooth out volatility. Also, stronger providers can afford to invest more of their with-profits funds in equities, which should make for better long-term returns. Of the nine insurers currently offering with-profits annuities, Standard Life and Prudential are, at present, the most financially secure.


How with-profits annuities work
Conventional pension annuities pay a fixed income for life, but force you to stick with the rates payable at the moment when you happen to retire - annuity rates are currently at close to an all-time low. In contrast, the income that a with-profits annuity pays varies year-by-year according to the performance of the insurer's with-profits fund.

On retirement, with-profits annuity investors set an anticipated bonus rate (ABR), an estimate of the annual bonuses your insurer will pay on its with-profits fund each year. The higher the ABR you set - typically between 1 and 5.5 per cent - the higher your initial annuity income will be. But if your insurer announces an actual bonus rate that is lower than your ABR, your annuity income will fall. Only if actual bonuses outstrip your ABR will your income rise.

This sort of product is the safest type of investment-linked annuity. Although your pension income may vary during retirement, the fact that with-profits funds keep back some profits in good investment years in order to sustain bonuses in leaner times should smooth out income volatility. Even so, these plans are more risky than conventional annuities.

Otherwise, with-profits annuities work in the same way as conventional contracts. The rates payable depend on your age and gender - women have, on average, longer life expectancies than men and therefore get lower rates - and income tax is payable on the pension.

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