Pensions: Alternatives to annuities are worth a closer look for retirees

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Ahead of a rule change, our reporter examines the three main options

MORE people are to continue investing during retirement as the popularity of pension annuities declines, it has been predicted.

Annuity rates are already at record lows and a European Court of Justice ruling last week outlawing the use of gender in underwriting means the fall in pension payouts for men is set to accelerate.

The rates offered to men are higher than for women because their lower longevity means providers assume they won't have to pay out for as long. But gender will be taken out of the equation at the end of 2012 and male pensions are likely to fall by around 5 per cent as a result.

Billy Mackay, of pension firm AJ Bell, said: "Essentially it means a man with a pension pot of 100,000 can expect to be almost 700 a year worse off under this ruling, and nearly 12,000 worse off over their predicted lifetime."

For the vast majority of people, annuities, which provide guaranteed income in retirement, will still be the only suitable option when they convert their pension savings into a retirement income. But as annuities become less attractive, more retirees are considering the alternatives.

Many believe the European judgement will encourage more men to delay buying an annuity or avoid doing so altogether, with the government next month removing the effective compulsion to buy an annuity by the age of 75.

The scenario raises the prospect of more people being mis-sold income drawdown contracts, a problem the Financial Services Authority has been watching for some time.

Tom McPhail, head of pensions research at Hargreaves Lansdown, said: "The majority of people should and will go for an annuity. But more people will go for drawdown, particularly in conjunction with the removal of the age 75 requirement in April."

These are several options available at retirement aside from annuities. Here are the main ones:

1. Income drawdown

Leaving your pension invested and taking money out of it in stages is the most widely used alternative to annuities. The sizeable drawback is that it involves leaving pension savings at risk of losses.

As it stands, investors effectively have to buy an annuity by age 75 because of an 82 per cent tax on death if they remain invested.

But rules coming into force next month will make it easier to avoid buying an annuity, with the introduction of new capped and flexible drawdown options, which will be available from the age of 55.

Under capped drawdown, individuals can leave their pension invested and take money out of it, provided the amount is no more than equivalent to the annual annuity income that could be bought with the fund.Flexible drawdown will allow investors to take any extra pension savings in retirement provided they have income of at least 20,000. That income includes annuities, and lower rates may make it harder for some men to meet the threshold.

Brian Steeples, managing director at the Turris Partnership in Glasgow, said: "The main advantage of drawdown is that you are not locked into current annuity rates. You can drawdown a flexible amount of income with the upper limit currently being about 20 per cent higher than conventional annuity rates. You can choose to receive nil income in any year, giving you the flexibility to switch your income on or off as your circumstances might dictate."

Under the new rules, investors are taxed at 55 per cent on death, meaning 45 per cent of the fund can be left to children, whereas nothing can be left from a conventional annuity.

But most experts believe that for drawdown to be a realistic option, investors must have a pension fund of at least 150,000 or so, although it varies with individual circumstances, including health and attitude to risk.

John Moore, of IFA Central Investment, said: "People have to understand they are taking a significant risk with drawdown. You need some kind of contingency in retirement to warrant taking the risk."

The problem is that if your pension fund falls in value, your income will eventually fall.

Steeples said: "In theory, you could completely extinguish your fund, which would be disastrous. It is therefore essential to take professional independent advice from someone who specialises in this area."

2. Temporary annuities

These are fixed-term annuities that run for between five and 15 years. The idea is that it removes the one-off element of buying an annuity by providing a guaranteed income for a period while keeping longer-term options open.

The income tends to be lower but someone who, by the end of the term, has developed ill health can then opt for an enhanced annuity, which pays more to reflect the reduced longevity. The main providers are Living Time and LV=.

The term is usually five years and many investors use these annuities as a safe haven for part of their pension fund while the remainder is left invested,

At the end of the five years you can buy another five-year annuity or tie into a lifetime annuity.

Steeples said: "For example, a 65-year-old male with a pension fund of 100,000 could receive an annuity income for five years of 7,333 (gross) per year and have around 60,000 of the pension fund invested for future income."

3. Variable annuities

These are also called hybrid or third way annuities and offer a combination of investment exposure and a guarantee of either the income, capital or both.

The appeal of variable annuities, offered by firms including MetLife and Edinburgh-based Aegon, is a combination of the potential to protect your income while enjoying some investment growth.Sales soared by a third last year as low annuity rates drove demand.

Variable annuities usually work by providing investors with a fixed income for a set period - ten years, for instance - while their pension fund is given more chance to grow. However, the income level usually drops after that period, leaving a risk of lower income later in retirement.

Again, advice is essential as the products can be complex and expensive. Steeples warned that the guarantee comes at a price.

"It sounds a good idea but you don't get something for nothing and the guarantees have to be paid for. And pay you will . Our experience is that the cost of the guarantee is too expensive to offer real value for money."