Guaranteed pensions can mean taking risks

There are pitfalls to some flexible annuities, says Alessia Horwich

(DANIEL BEREHULAK / GETTY)

American life company the Hartford pulled out of the UK pensions market earlier this month.

You'd be forgiven for missing this news, but the move sent ripples through the financial world. One of the Hartford's most popular products, a variable – or third-way – annuity, crumbled before huge market volatility and poor long-term interest rates. Fears were raised about the future of this flexible type of retirement income plan, which is designed for those who want to play their chances in the investment market, but still need the reassurance of some guaranteed income.

Third-way annuities are essentially a middle ground between the absolute security of a fixed annuity and the risk of an income drawdown pension, which is dependent on market movements but is very flexible. Unlike fixed annuities, the annual income provided by variable annuities can be increased if the invested fund grows well. But if the fund does badly, the guaranteed income will never drop.

It sounds good, but there are pitfalls. For starters, the guaranteed fixed income will initially be as much as 30 per cent lower than a traditional annuity. Should the fund grow, this will rise, but that growth will depend on wider market conditions. And the fund requires much more management. Typical fees come to between 0.5 and 1.5 per cent a year, but they can total as much as 3 per cent annually.

There is also the cost of the guarantee or insurance policy that assures the fixed income element of the plan. However, the economic crisis put underwriters on their guard and these guarantees are now much costlier. "When you get massive volatility in the markets, the price of the guarantee increases significantly," says Bob Bullivant, the chief executive of pension advisers Annuity Direct. "Once the price gets too high, the product just doesn't work."

Indeed, the combination of escalating costs and the fiendish complexity of the structure of these products is causing providers problems. IFAs are reluctant to sell them because they are difficult to explain, and even then, until the cost of the guarantees fall, they remain too expensive for most.

However, several UK providers are still selling variable annuities. "For a correctly positioned and correctly priced product, the market is still substantial," says Mark Locke, a spokesman for insurer Aegon. "It's not a shrinking market; it's viable and growing, especially in the current climate. People are searching for alternatives to falling annuity rates but are still looking for security."

For those who are looking for an alternative, a with-profits fund such as the Prudential's with-profits pension annuity is an option. Like a conventional annuity, these pay a guaranteed annual income and, like a variable annuity, they will pay out more if your fund does especially well. However, any extra payment will be in the form of a bonus, and these have been subject to dramatic cuts recently.

A riskier option could be to split your pension pot between a fixed annuity and an unsecured pension. "If you want equity exposure you can get it through a drawdown plan. If you want security you can get it through a conventional annuity," says Tom McPhail of Hargreaves Lansdown. "If you want both you can simply buy a bit of both. This is more efficient."