Retirement income: the least-worst options

If you're on the verge of retirement you probably aren't too impressed with your pension options. In the past,anyone hitting retirement age tended to use their pension savings to buy an annuity. They then had an income for life and that was that.

But due to rock bottom gilt yields, annuities aren't looking too attractive at the moment. Say you have toiled away for years and saved up £500,000 in a pension. You might have briefly thought yourself rich. But a quick look at the annuity tables will prove that you are not. Your income via an annuity will be around £30,000 if you accept that it will not be protected from inflation. Go index linked and it will be more like £18,000.

Given this, many people are turning to drawdown instead: this allows you to keep your pension money invested, take an income from it, and still leave the option open of buying an annuity later.

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The problem? You remain exposed to the whims of the markets at a time when you really shouldn't be, and the capped drawdown rules (the ones that affect most people) are such that you don't get any more using them than from an annuity: someone with a £500,000 pot could withdraw a mere £27,720 every year on current calculations. Not very attractive is it?

Still, there is a third way of sorts an investment-linked annuity. With these you get an initial annual income set at about the same level it would be if you took an annuity (although you can vary it). Then your money is invested and your income then varies in line with the performance of the assets with some kind of minimum guarantee.

Richard Evans in The Daily Telegraph uses as an example a scheme offered by the Prudential. The maximum income you can take at first on your £500,000 is £37,300 and the minimum is £21,350. Choose the minimum and it won't fall (this is the minimum guaranteed income). Choose the maximum and it may: for your income to stay at £37,300 the underlying fund needs to grow at 6%. If it grows at only, say, 4.5%, your income would fall to make up the missing 1.5%. But if it grows by 9% your income rises.

This doesn't sound too bad, but it's not perfect. The charges on a product like this are bound to be high, and just as with drawdown you are tying your fortunes to those of the markets at a time when you should be taking little or no financial risk.

Worse, you aren't just tying yourself to market risk, you are tying yourself to the fund manager. Prudential links these plans to its with-profits fund: this has done better than most. But it still lost 20% in 2008. How many pensioners could have coped with that hit to their incomes?