How To Profit In Retirement

Could an investment-backed annuity help you make the most of your income in retirement?

If you're buying an annuity to convert your pension into an income, you may not be terribly impressed by the choice on offer. Annuity rates are pretty low right now, roughly half as generous as they were in the 90s. And since the rate is set when you buy an annuity, you could be locked into a relatively small income for the rest of your life.

But there are ways you can get more out of your pension. Did you know you can buy an annuity which is linked to the performance of a with-profits fund?

True, the once popular with-profits investment strategy has fallen from grace in recent years. All the same, a with-profits annuity could lead to a better income in retirement.

If you're a bit vague on with-profits, let me give you a quick recap:

What is with-profits?

A with-profits fund manager will invest cash on your behalf in a range of assets -- often shares, bonds and/or property -- with the aim of providing you with a good return.

Normally, if a fund grows by say 10% over a year (after charges), you'll enjoy a 10% boost to the value of your capital. However, with a with-profits fund, the return isn't rigidly linked to how well it performs.

Your return is paid each year by an annual bonus. The idea is when the fund has performed well, some of the growth will be held back to pay bonuses in the years when the fund hasn't done so well. In this way, you should get a `smoothed' return which doesn't fluctuate wildly even though part of it will be invested in shares.

Unfortunately, certain funds came unstuck after the tech bust in 2000, when previous bonus rates had been set too high. That left little in reserve to continue paying bonuses as the market fell over the next few years. Indeed The Fool has been very critical of with profits funds. We haven't liked their poor performance and the fact that the funds lack transparency and are hard to understand.

That said, some funds weathered the storm better than others and not all are necessarily bad investments.

How do with-profits annuities work?

A with-profits annuity is bought using your pension fund. The income it provides has the potential to rise during retirement through investment in a with-profits fund.

You select the starting level of income you want to receive by choosing an `Anticipated Bonus Rate' (ABR) within a set range -- typically between 0% and 5%. You should choose the ABR depending on how well you think the with-profits fund will do in the future.

Your income in future years will rise or fall depending on the difference between your chosen ABR and the annual bonus rate declared by the fund manager. 

If you select a high ABR, you'll receive a higher income initially. But with a higher reward comes higher risk. Your income could fall if the with-profits fund doesn't perform well and the declared annual bonus is lower than your ABR. The reverse is true if you pick a low ABR and the declared annual bonus is higher.

The table below shows how the annuity income varies based on an ABR of 0%, 3% and 5%.

With-profits annuity rates (£50,000 purchase price)

Source: Investment Life & Pensions Moneyfacts. Rates as at 1 June 2008 and are based on a purchase price of £50,000. No guarantee period or spouse's/partners benefits are included. * Maximum ABR available is 4%.

As you can see, by selecting an ABR of 5%, you'll receive an income which is higher than a level annuity plus there's potential for your income to rise further depending on fund performance. Remember that a level annuity pays out the same income every year and will be eroded by inflation over time.

If you can get by on a lower starting income, you may prefer to choose an ABR of 0% or 3% instead. Your income will rise the following year if the annual bonus declared by the fund manager is higher than your chosen ABR, meaning you could enjoy an income which may, in time, be greater than a level annuity.

To give you a better idea, the bonus rate declared for Prudential's with-profits annuity was 2.75% in 2007, while the underlying fund actually grew by 7.2% over the same period. If you had chosen a 0% ABR your income would rise, while a 5% ABR would see your income fall.

Minimum income guarantee

Crucially, there's a guarantee that your income won't fall below a set minimum level regardless of how the fund performs. By choosing a 0% ABR, your income will never fall below its initial level. But there's a risk if you choose a higher ABR because the minimum income will be set at a lower level. For instance, if you choose an ABR of 2%, your minimum income guarantee could be set at say 65% of your starting income.  

You may also receive an additional top-up bonus each year which -- along with the annual bonus -- affects the level of income each year. The additional bonus is likely to change more frequently and by a greater amount than the annual bonus, but it is not guaranteed.

So that's with-profits annuities in a nutshell. 

Should you go for a with-profits annuity? 

You could buy an index-linked annuity which inflation-proofs your income or one which rises by a fixed amount each year instead. But the trade-off is your income will always be significantly lower than a level annuity at first.

A with-profits annuity allows you to possibly get round that by selecting a high ABR. But the problem is your income will only stay higher than a level annuity if the with-profits fund performs well -- and that's a big if.

If you're tempted to go for a with profits annuity, it makes sense to consult a good independent financial adviser who could help you pick your fund. However, there is no guarantee whatsoever that the adviser will pick a fund that will perform well in the end. So if you're risk-averse, it's probably best to go for a more conventional product such as a level annuity or an index-linked one.

More: Give Your Pension An £11,000 Boost | A New Way To Boost Your Pension Income