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Rock bottom rates are forcing people on the brink of retirement to seek alternatives to standard annuities. One increasingly popular option is the with-profits annuity, which promises higher returns.
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At retirement, the bulk of a personal pension fund must be used to buy an annuity - a regular income for life. The quest for the best deal is crucial since buying an annuity is an irrevocable step. You cannot change your mind or switch to a different arrangement whatever happens to rates or your circumstances in the future.
But standard annuities, which pay a guaranteed fixed income, have been offering increasingly poor value, with rates reaching 30-year lows over the past 12 months.
With-profits annuities offer the prospect of higher returns but involve more risk. This is because they are linked to the performance of a with-profits fund that puts money into the stock market and other investments.
But risk is balanced by allocating profits from the underlying investments in the form of annual bonuses, which cannot subsequently be taken away, and by holding back profits from good years to subsidise bad ones.
Experts say the risks are low enough for with-profits annuities to be worth consideration. Hugh Lachlan, annuity consultant at London specialist adviser Annuity Solutions, reports that three in four of his personal pension clients take with-profits annuities, far more than in the past.
He says: 'Rates from fixed annuities have fallen by about half on average during the Nineties because providers invest heavily in gilts - government fixed-interest securities - and gilt yields have been much lower.
'People are also living longer because of healthier lifestyles and medical advances.' Lachlan adds: 'In my opinion the chances of fixed rates improving are slim because long-term interest rates are projected to remain low and this will mean low gilt yields. With-profits annuities are clearly a growth area as they offer some way of escaping the low fixed rates.'
Only half-a-dozen insurance companies offer with-profits annuities, but this should present no difficulties. At retirement, an annuity buyer does not have to take one from their personal pension plan provider, but may choose from another company - the 'open market option'.
Most with-profits annuities work along the same lines. At the outset the client accepts an anticipated annual bonus rate of up to 5% - sometimes 5.5% - and if this rate is exceeded by the bonus rate declared, income rises by the difference between the two. If, however, bonus rates are lower than the anticipated rate, income falls accordingly.
When the maximum 5% or 5.5% predicted bonus rate is selected, there is generally little to choose between a with-profits arrangement and a fixed-rate annuity at the outset. The client will benefit only if bonus rates turn out to be higher than the anticipated rates.
Andrew Haxton, director of adviser Bridgegate Annuities in Chester, says: 'Current total bonus levels can be as high as 9% a year and this leaves a fair margin from a 5% anticipated level. The chances of a financially strong company achieving bonus rates of less than 5% in the foreseeable future are slim.
'But there is a slight risk that a significant improvement in average life expectancies could have a negative effect on returns in the future. The bonus rates declared reflect mortality rates as well as the performance of the underlying investments.'
• Annuity Solutions 0171 628 3455, Bridgegate Annuities 0800 783 5280, Annuity Direct 0500 506575.
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