Profiting from a well-planned retirement

The last thing people want to worry about in their sunset years is their pension and whether or not they picked a suitable savings scheme. Anyone with a personal pension nearing retirement will have plenty to worry about ­ annuity rates have been declining and there is the prospect of being tied in to low returns on gilt-edged stock.

The last thing people want to worry about in their sunset years is their pension and whether or not they picked a suitable savings scheme. Anyone with a personal pension nearing retirement will have plenty to worry about ­ annuity rates have been declining and there is the prospect of being tied in to low returns on gilt-edged stock.

For some years, it has been possible to buy unit-linked annuities, from companies such as Equitable Life, Merchant Investors, and Allied Dunbar, where the pension fluctuates in line with the value of units in unit trusts, but the fact that the payments can go down as well as up puts off most risk-averse savers.

With-profits annuities are a sortof half-way house, which re-invest pension funds in a mix of cash, gilts, shares and property; they pay a minimum annual pension like a level annuity, and top it up each year by adding an annual bonus based on the performance of the investments. Equitable Life pioneered the concept back in 1987 and there are now half a dozen companies offering a range of with-profits annuities with varying degrees of risk and reward.

Anyone buying a standard with-profits pension chooses an "anticipated bonus rate" ­ that is, a target for the annual bonus on the with-profit plan. Once selected this target cannot be altered so it must be chosen with care. Every year, each company declares a special bonus, (at present between 5 per cent and 6 per cent). If the special bonus beats the target the pension increases by the amount of the outperformance. The lower the target the easier it is to beat, but the initial pension will be lower. So a zero target would pay a pension that would start relatively low but should ensure the pension increases in most years. A higher target rate is harder to exceed, so increases are smaller, and payments could even fall if bonus rates drop below the target ­ though the initial pension will be much larger for the same initial outlay.

The graph shows the relative performance of different annuities over the past decade. For an initial investment of £100,000 back in 1989 a couple, then both aged 60, could have bought a level pension of about £10,800, with no reduction on the death of the first spouse. A pension escalating at 5 per cent a year would have qualified for an initial pension of £7,000, which would now have climbed to about £11,500.

A fully-indexed pension guaranteed to match inflation would have been worth less than £6,000 initially, because inflation was running at 8 per cent in 1989. Inflation has fallen and the fully index-linked guarantee would only be paying £8,400 now, after 10 years. A unit-linked pension, assuming a 10.2 per cent total return, would have started at £10,600, but as inflation has fallen it would only pay out about £11,000 this year, and in several years it would have seen alarming falls.

An Equitable Life with-profits pension with the maximum permitted 10.22 per cent target to beat would have started at the same point as a unit-linked pension and been almost near the level pension. In the first few years it would have been the best choice, but as average returns on with-profits policies have declined, the target would have been harder to beat and the pension would have shown little growth over the past five years, reaching only £12,000 this year. A with-profits pension with only a 3.5 per cent growth target would have paid out only £5,900 initially but would have found it easier going in a lower inflation and lower growth market; by this year it would have emerged as the best buy, paying almost £13,000 in 1999.

Starting five years ago, unit-linked pensions would have come out best, but a with-profit pension with a high target would have also beaten a level annuity, a low target option would almost have caught up with the level annuity, and the return on index-linked escalating pensions would still be below the level annuity.

The range of growth rate targets, 10 years on, has been reduced. Equitable Life now offers a choice from zero to 6 per cent. Prudential, which entered the market eight years ago with a maximum target rate of 10 per cent, now offers a range of targets from zero to 5.5 per cent. In August, Norwich Union and CGU entered the market, and Scottish Mutual brought out a brand new product just two weeks ago.

The older products, including those from Equitable Life and Prudential, do not guarantee a level below which pensions cannot fall in bad times, but the newer ones do. Both CGU and Norwich Union now assume anticipated growth rates in the fund of between zero and 5 per cent a year. Once again, the higher the target the larger the initial pension but the lower the possible bonus added each year for beating the target, and the greater the risk of the bonus falling short of the target and reducing the pension for the following year.

Both providers guarantee the pension will never fall below the minimum which would have been paid in year-one if you had started with a zero per cent target. CGU accepts a premium of £15,000, compared with £20,000 at Norwich Union. Scottish Mutual offers a choice of target bonuses in half-point steps from zero to 5.5 per cent, and the minimum premium is £20,000.

Scottish Widows which entered the market in 1995 differs because its funds are invested in a unitised fund that fluctuates in value, and payments are reviewed monthly rather than annually. The target growth rates go from zero to 6.5 per cent, and there is no guaranteed minimum pension. Sun Life assumes a constant bonus target of 4 per cent and offers all its pensioners a starting income, usually between 85 per cent and 90 per cent of the best level annuity available and a minimum income guarantee, but the minimum fund is £50,000.

It would be unwise to select any with-profits pension provider without consulting an independent financial adviser to discuss suitable schemes and especially the difference between the value of the fund and the bonuses promised.Advisers will also keep an eye on the current level of declared bonuses, which, in some cases, are under 6 per cent, putting some pay-outs at risk. In these cases at least, they earn their commission from up to 1.5 per cent of your fund.