Caught short in old age

The event didn't make the front pages of many newspapers, but for tens of thousands of people, the effect was shattering. They discovered the income many hoped to receive for the rest of their lives suddenly dropped in value by up to 4 per cent almost overnight.

Those hit are among the most vulnerable sections in society - working people who are about to retire. Normally, they would expect to cash in their pension fund in order to buy an annuity, an income for life. In September, a fund of pounds 100,000 might buy an annuity paying a level life- time income of pounds 11,382 for a man aged 65. The same fund today buys just pounds 10,920.

For 8 million people with a personal pension or in "money-purchase" schemes, which rely on annuities too, the income they may be locked into for the rest of their lives will vary alarmingly. More frightening is the way the value of pensions has fallen in the past five or six years.

Annuities are mainly linked to the value of long-dated gilts. Considered a safe investment, these are Government bonds issued as a means of raising money. They can rise and fall, according to whether interest rates are high or low. Low interest rates have therefore affected annuity rates.

Figures from specialist adviser Annuity Direct show that in 1990, when rates were high, a fund of pounds 100,000 might provide an annual income of pounds 15,785. Now, it is under pounds 11,000. In other words, the falling gilt market has in the past six years pushed down pension incomes by more than 30 per cent.

Worse, the incomes available from annuities are likely to drop even further. Annuities also depend on mortality. The longer people live, the more it costs to provide a lifetime income.

This month, new figures are expected to show that people are now living 15 per cent longer than in the past, to the age of 82 for a man, on average, and 86 for women. Roughly, this means you need 15 per cent more fund to get the same life-time income. To get even pounds 10,900, a 65-year-old will need not pounds 100,000, but closer to pounds 115,000.

In his 1995 Finance Act, the Chancellor, Kenneth Clarke, tried to provide a solution, allowing people to get some income from their pension fund before they buy an annuity.

While investors waited for annuity rates to improve, they could draw an income worth anything between 35 and 100 per cent of what an annuity would give. By age 75, they would have to buy an annuity. The reform has spawned a huge pounds 1bn market in the new facility, known as "income drawdown". Has it worked?

Steve Bee, pensions manager at Prudential, the insurer, says: "The reform has not benefited those who suffered most because of low annuity rates. And those who have benefited never needed it in the first place."

There are three crucial reasons. The first is charges. To pay the person who sold the income drawdown facility will cost up to 5.6 per cent of your fund, or pounds 5,600 on a pounds 100,000 fund. That compares to 1 per cent in commission, or pounds 1,000, if you buy an annuity.

If the investments in your fund grow enough, they may make up for the charges. But the growth also has to cover any money you take out, otherwise you will get less in future years.

The upshot is that drawdown is only for the relatively well-off who do not need the maximum income. Most providers insist that you have a fund of more than pounds 100,000 unless you have income from elsewhere.

Those who need an escape from poor annuity rates can take advantage of some opportunities on offer. Most annuities are bought with pre-fixed incomes. More than 70 per cent of annuitants buy incomes fixed at a level rate. For a fund of pounds 100,000, this might provide an annual income of pounds 10,000.

Incomes can also escalate either by a fixed rate (3 or 5 per cent) or in line with inflation. But the price is an initial income up to 30 per cent less, or pounds 7,000 for the same fund.

Two options offer the chance to benefit from gains in the equity market. These are with-profits annuities and unit-linked annuities.

With-profits annuities link the income you get directly to the performance of the with-profits fund. It will vary according to the bonuses announced by the fund, which in turn depend on fund performance. Therefore, a fall in the market may trigger lower incomes. While incomes from with-profits annuities will only go up if bonuses do, unit-linked annuities benefit in full from rises in the equity market. But the pay-back is that unit- linked annuities offer no protection against stock market falls.

The simplest way of boosting the income from an annuity is to shop around. The overwhelming majority of policyholders buy annuities from the company that holds their fund. If they took took money elsewhere, their income could be vastly improved. Annuity Bureau figures show that, as of 4 December, a 60-year-old man with a fund of pounds 75,000 could buy an income of pounds 7,969 a year from Britannic Assurance. With Scottish Amicable, the annuity would be just pounds 6,700.

Annuity Bureau's managing director, Peter Quinton, said: "People who are purchasing an annuity must shop around. Not to do so would be the same as pouring money down the drain."