Fight back against falling rates

As savings providers rush to slash rates, there are other secure – and 
some riskier – options to generate a decent income, writes Sylvia Morris

Pensioners who use bank and building society accounts to boost their retirement income saw their interest payments halve in 2008. The devastation caused by the 3.5 percentage point drop in base rate from 5.5 per cent to 2 per cent during 2008 means they earn less than £25 a month before tax on savings of £10,000 in easy-access high street accounts.
This meagre amount is expected to fall further this year. Some economists expect the base rate to fall to 1 per cent or even zero as we battle recession or even depression.

Plunging rates
At the start of 2008, a £10,000 deposit earned 5.65 per cent before tax in Halifax’s Extra Income, a branch-based account designed to pay monthly interest to those living off their savings. That rate has already more than halved to 2.75 per cent and monthly interest has plunged to just £22.92 before tax, down from £46.33 a year ago.

And the rate could go even lower – it has not yet been cut following the one percentage point cut in December. At 1.75 per cent, monthly interest will drop to £14.58 on £10,000.

So how do you earn as much income as possible with little or no risk? First, look to fixed-rate deals from banks and building societies where you can still earn double the base rate (see page 62).

Another secure option is to lock into an annuity (an income for life) with your pension pot from an insurance company. Some companies have been cutting rates in recent weeks and rates are expected to carry on falling.

Figures from independent adviser Annuity Direct show level rates fell from £7,855 in August to £7,688 by the start of December for a 65-year-old male for a £100,000 lump sum.

Do not automatically buy the annuity with the company that built up your pension. Once you have bought an annuity there is no going back, but you can boost your income dramatically by going to another company. The rate depends on factors such as your age, sex and health – the older you are and the worse your health, the better the deal.

Stuart Bayliss from Annuity Direct says: ‘You can improve your income dramatically by picking the best rate for you. Two-fifths of 65-year-olds are eligible for an enhancement on the rates – including people with high cholesterol, high blood pressure or Type 2 diabetes.’

Your return will also depend on the type of annuity you select, whether it be a joint annuity with your partner, one that stays the same or one that increases every year at say 3 per cent or 5 per cent, or an inflation-linked version.

But the last option is expensive. If you are aged 65, £100,000 buys you around £4,700 a year income on an index-linked annuity and £7,700 for a level annuity. This means for an average life expectancy of 86, that £4,700 has to rise by 5 per cent a year for you to break even. But inflation is expected to drop sharply soon.

Laith Khalaf, pensions specialist at independent financial advisers Hargreaves Lansdown, says: ‘Index-linked annuities are poorly priced. The solution we suggest is an annuity that rises by 3 per cent a year based on average life expectancy of 86.’ This gives you a better starting income of £5,703 and you will break even if you live to 86.

Capital risk
You can also increase your income by taking some risk with your capital by looking at gilts and corporate bonds.

First up on the risk scale are government bonds, or gilts. The yields have fallen recently, but there are still some decent returns around. David Kauders from Kauders Portfolio Management, which specialises in gilts, says: ‘The government is launching massive amounts of new stock, but there are plenty of buyers around, including pension funds.

You can still lock in at 3 per cent on short-dated gilts and 4 per cent on 15- to 20-year stock.’

That might not look like a huge return, but Kauders thinks interest rates will remain low for a very long time. He warns against opting for index-linked and undated gilts because of the risk involved.

As any capital gain is tax-free on gilts, higher-rate taxpayers will do better to go for lower-yielding gilts, which will give then a relatively higher capital gain, while basic-rate taxpayers can go for a higher yield.

Corporate bond funds, where investment managers pick and choose IOUs issued by companies, offer higher yields. These have been rising in recent weeks from below 3 per cent to as high as 9 per cent. Even cautious funds have yields of more than 5 per cent.

The credit crisis might have been rolling on for more than a year, but for investment-grade bonds of non-financial companies, it did not really start until after the demise of Lehman Brothers in September last year.

Independent financial advisers recommend sticking to funds that hold investment-grade bonds (those issued by companies that have a good solid credit rating), rather than non-investment-grade (‘junk’) bonds whose time may come in the months ahead.

There is a very good chance that default rates – where the companies issuing them are unable to meet the interest payments or, in extreme cases, repay the capital – will rise. But even if they rise by half – the long-term average is 1 per cent – the income on investment-grade bonds will still look attractive.

Mark Dampier, head of research at Hargreaves Lansdown, says: ‘Stick to funds investing in investment grade bonds. Some offer attractive yields and there is a good chance of the price of the bond going up at some point, so you could make some capital gain too.’ For the ultra-cautious, he picks the Jupiter Corporate Bond fund.

Tim Cockerill, head of research at Rowan & Co Capital Management, says: ‘Some corporate bond funds such as those from Invesco Perpetual and M&G invest as much to conserve capital as to provide income.’

Brian Dennehy at Dennehy Weller picks the M&G Corporate Bond and Investec Sterling Bond funds.

Equity income
Higher up the risk scale you could consider equity income funds for a home for part of your money. These are funds that aim to provide growing income over the years. There is, however, a widespread expectation that companies will cut dividends from here on in, bringing down yields from their current level, with highs of 7 per cent plus.

But Dampier says: ‘With yields at this level, a 10-20 per cent cut in dividend is not too bad. Not all companies will cut their dividends.’ He picks Artemis Equity Income, Invesco Perpetual Income and Jupiter Income. Cockerill also likes Artemis Equity Income, along with Threadneedle Equity Income, while Dennehy picks Liontrust First Income and Newton Higher Income.

A word of warning though: watch out for new products expected to come on sale in droves that offer huge fixed-rate income returns but also involve you taking an excessive risk with your capital. A recent bond, for example, was offering 8.08 per cent fixed for five years, but the value of your capital would have been linked to the performance of the
FTSE 100 index and the Dow Jones Euro Stoxx 50 index.