Personal Finance: As annuity rates rise it may be a good time to 'buy' a pension

If you have a personal or money-purchase pension plan, and are near retirement, keep a sharp eye on gilts and the stock market to get the best deal

Buying an annuity may sound just a tad less interesting than playing roulette, but they are both a sophisticated form of gambling, and the stakes can be just as high. Anyone with a personal pension will have to roll the annuity dice sooner or later. Rates have rallied almost 5 per cent since January, so should you be thinking of grabbing a deal while the going is good?

Buying an annuity may sound just a tad less interesting than playing roulette, but they are both a sophisticated form of gambling, and the stakes can be just as high. Anyone with a personal pension will have to roll the annuity dice sooner or later. Rates have rallied almost 5 per cent since January, so should you be thinking of grabbing a deal while the going is good?

If you have a company pension scheme which still pays a pension based on final salary and length of service, by all means skip this article. But, if you have a personal pension or a money purchase company pension plan and are thinking about retirement, you should definitely be watching the performance of your plan and the latest trends in annuity rates while also calculating how long you're likely to live, and the likely course of inflation in order to optimise your pension's value.

More and more people can afford to be flexible and choose when they take their personal pension, but under current rules you must use your pension fund to buy an annuity, ie, a pension, by the time you are 75.

Once you buy you can't get your capital back, so, for better or worse, you are stuck with what you've bought. Most life assurance companies will sell you an annuity, and you don't have to use the one that managed your pension fund. At any one time some insurers offer better rates than others, so it pays to keep a close eye on "best buy" tables for various types of annuity and, perhaps, seek advice from a specialist independent financial adviser (IFA) before taking the plunge.

The current annuity rate decides how much pension you get as a percentage of the value of your fund. Annuity rates in turn are linked to the yield on gilt-edged stocks that mature about 15 years hence, as these are the things insurers buy to give the income for your pension. As gilt yields have fallen, mainly in line with falling inflation, our graph shows that the initial pension - from a £100,000 pension fund for a man of 65 if he wanted the pension to rise 3 per cent a year, and provide a 50 per cent widow's pension for a wife aged 62 - fell from £11,000 in 1990 to under £6,000 earlier this year.

But most people who waited have enjoyed substantial rises in the value of their pension funds, especially if they have been invested mainly in equities. It is not unusual for personal pension holders to have a "pot" of £100,000 as they approach retirement. For many upcoming pensioners the rise in equity values has more than offset the fall in annuity rates.

The third element in the calculation is how long you're likely to live to enjoy the pension. At any one time the older you are when you buy your annuity, the more you get for your money as the pension fund will have had longer to grow and you'll have less time to enjoy the pension. A man of 60 in average health can now expect to live another 24 years, and a woman of the same age another 27.

Right now a man of 60 with a "£100,000 pot" could expect a fixed pension of about £8,000 a year for life with no widow's pension to follow, but a 65-year-old could expect £9,000 and a man of 70 could expect around £10,600 a year. Women get a lot less at the same age, from £7,500 at 60 rising to £9,200 if they wait until they are 70, and pensions with a spouse's residule pension pay less than for a single person.

The fourth element in the equation is inflation. Most pensioners still choose a level annuity, guaranteed for five years, so if you die within that time your heirs will get the pension - though your capital, of course, has gone for good. If you want an index-linked pension which will rise in line with inflation you will get less to start with.

A man of 60 with a "£100,000 pot" could choose a level annuity of about £8,000 or an initial £5,000 with an annual 5 per cent escalator. Which is best depends on the actual inflation rate and how long you you will live. It takes roughly 12 years for a man's indexed pension to catch up with the level pension (slightly longer for a woman) and double those times for the total pay-out to catch up, but over 20 years a level pension will lose 40 per cent of its purchasing power with inflation at 2.5 per cent a year, and 64 per cent with 5 per cent inflation.

So, what should you actually do? Annuity rates have rallied almost 5 per cent since January but the stock market has fallen 10 per cent. Looking forward, if inflation stays under control and the government keeps a budget surplus, reducing the amount of gilts it needs to sell, then gilt yields and annuity rates need not rise much further, says Peter Quinton, managing director of the Annuity Bureau, a specialist London-based IFA. At the same time share prices could go on falling, so there's no over-riding reason to delay buying an annuity, especially if you are not so fit. Even if you are in the pink, but you definitely want to retire within the next year or two, it might be wise to ask your pension fund manager to shift some of your fund into gilts or even cash.

Mr Quinton thinks index-linked annuity rates are currently quite generous, as it is a very competitive business; current inflation expectations are the lowest for a generation; and insurers haven't yet fully incorporated rising life expectancies into their calculations.

But if you want to hedge your bets, you could consider a with-profits annuity that pays less at first but offers annual bonuses linked to the future performance of the stock market. Half a dozen insurers now offer them, and Mr Quinton thinks we may see some more innovations before the end of 1999.

Next week we will look at those currently on offer.

The Annuity Bureau offers readers a free general guide, 'You and Your Annuity'. Call 0171-620 4090 for a copy