That crock of gold waiting for you at retirement could turn turn to dust if you don't plan properly

The Government last year decided to allow personal pension policyholders to wait until age 75 before requiring them to use the accumulated funds to purchase an annuity, fixing income for the rest of their lives.

This initiative was intended to give more flexibility.The objective was to allow pensions holders to pick the optimum point to buy an annuity. In the meantime they could invest the capital and draw an income.

But according to Bob Woods, a partner in the Leicester-based independent pension consultants Mattioli Woods, this freedom could be misused, causing a pensions disaster on an even greater scale than the mis-selling of personal pensions in the late Eighties.

Thousands of people on the point of retiring with a "crock of gold" in their personal pensions plan could now be persuaded to transfer their funds, with competing insurance companies promising them an attractive income.

Taking too much income from the pension fund capital - instead of buying an annuity - could eat up the capital if it failed to earn the return needed to provide an adequate income in the meantime.

Until the 1995 Finance Act, personal pension policyholders had to secure their pensions at retirement through the purchase of an annuity, an annual income fixed for the rest of their lives.

Annuities pay out more than a similar sum invested would do because the annuity includes an element of compensation for the capital that was used to buy it. But timing the purchase of an annuity has always been a tricky business, because the annual payment that a given amount of capital will buy is heavily influenced by current interest rates as well as by the age, sex and therefore life expectancy of the purchaser.

Once purchased, however, the annual payment is usually fixed for the rest of the pensioner's life.

He or she will not automatically be protected against inflation and no longer has any claim to the capital sum used to buy the annuity.

It is possible to buy annuities that do keep pace with inflation, and annuities that guarantee to repay some of the capital if the pensioner dies within, say, five years of retirement.

It is also possible to buy annuities that pay out a pension for surviving spouses. But all these improvements are expensive and result in a sharp reduction in the basic pay-out.

Five years ago a male aged 65 with a pounds 50,000 pension fund on retirement could expect to buy a level annuity of around pounds 7,500 a year for life.

Since then a combination of factors, including falling long-term interest rates, increasing longevity, operating expenses and shareholders profits have helped to undermine the value of the annuity contract, and the same pounds 50,000 might now only buy pounds 5,500 a year.

To meet this problem the new Act's provisions now allow anyone on retirement to defer buying an annuity, and in the meantime draw a pension from the underlying pension policy proceeds, at a rate that is itself based on the yields available from 15-year gilts.

This more flexible method of pension payment allows the pensioner to fix a higher level of annuity by waiting until he or she is older, and interest rates hopefullyhigher - or so the argument goes.

In the unfortunate event of the pensioner dying before age 75, all of the funds will still be intact to provide either a widow's pension or be distributed to beneficiaries, albeit less a tax charge - choices not available once an annuity has been purchased.

On paper, then, the deferment of annuities looks extremely attractive, with the possibility of a higher annuity, or greater inflation protection from a given amount of pension capital, allied to the substantially improved position in the event of death. Mr Woods points out however, that the theory is flawed in a number of ways.

First, there is an implicit assumption that when interest rates are low, annuity rates are also low, and therefore better investment returns can be obtained elsewhere.

But, he argues that "this assumption does not stand up under close scrutiny. When interest rates and, therefore, long-term gilt yields are relatively low, the only fundamental alternatives are asset-backed investments, mainly equities and property".

However, the scenario of low interest rates is no guarantee that either equities or property would out-perform them.

"The last five years have seen a steady fall in interest rates and a stock market performance which, up until the beginning of the bull market this year, would have failed to achieve the investment return necessary to maintain the pensions," he says.

The message from all this is crystal clear: Drawing a predetermined amount from a pension fund for an investment that does not earn the necessary return makes it unlikely the capital will ever catch up.

The inevitable outcome will be that the policyholder's pension will have to be reduced at some stage - indeed, the sooner the better - to avoid eating up all the capital.

Mr Woods argues that if investment risk is to be avoided, it is unlikely that insurance companies will be able to offer investment funds suitable for underpinning pension payments, which can not even match annuity returns, let alone surpass them.

He believes the insurance industry is almost certainly aware of the problems associated with managed pensions.

"It is perhaps the challenge of the '90s for companies to develop the investment products that the market so desperately needs," he says. "Or will they let the public down yet again?"

To reduce the risk of eroding the capital to generate income, while minimising or eliminating investment risk, Mattioli Woods has created a bespoke asset and liability matching module to manage the fund.

Even then, regular and active monitoring is required to ensure that the investment programme stays on track.