Annuities versus Income Drawdown – which is the best pension option?
When you retire, your pension does not, in itself, provide an income to support you. In fact you have to make some key decisions about how to convert your pension ‘pot’ into an income stream; those decisions are some of the most important financial ones you will ever make because you will not be able to make any significant changes if you make a mistake.
If you are one of the few people still lucky enough to have a ‘final salary’ pension, then the scheme does the hard work for you. You will get a retirement income based on the number of years you were in the scheme and your salary at retirement.
However, you are more likely to be in what is called a ‘money purchase scheme’, where your pension contributions are invested in shares, bonds and cash. The amount that your pension pot grows to depends on how well those investments perform over the years.
At retirement you have two choices:
1. Convert your pension into income by purchasing an annuity
2. Keep the pension invested and withdraw money when you need it; this is called income drawdown.
(both allow retirees to take up to 25% as a tax free lump sum)
What are Annuities?
Most people buy an annuity with a lump sum of cash from their pension pot; an annuity gives you a guaranteed, taxable income for the rest of your life, giving you certainty throughout your retirement. If you have a relatively small pension, an annuity is probably the right option for you, however it does not give you the flexibility of income drawdown.
How much do they pay?
Annuity rates have fallen significantly over the past few years – because of falling yields on Government bonds, low interest rates and increased life expectancy. A 65 year old man with a £100,000 pension pot could currently expect to buy a flat income worth £5,580 at best. This would be just £3,260 as a starting income if he wanted it to rise in line with the retail price index each year, guaranteed for 5 years. In addition, once you have bought an annuity, you cannot change it, even if annuity rates improve in the future. (Source of annuity figures: thisismoney.co.uk)
Where can I get one?
Your pension provider will offer you an annuity but your adviser should shop around for the best deal, taking the ‘open market option’. This can increase your annuity income by as much as 20%. If you have health problems, consider an ‘enhanced annuity’ which pays you more because you are expected to live for a shorter time. See our blog ‘Enhanced and Impaired Life Annuities for a higher retirement income’.
What is Income Drawdown?
This option will allow you to take the tax free lump sum immediately, from the age of 55 onwards, and leave the remaining pension pot invested which can be used to either provide an income within government defined amounts known as GAD (Government Actuary’s Department) rates or an income can be deferred, up to the age of 75, until you decide to take an annuity. It is more risky than purchasing an annuity, because your pension remains in investments that may go up or down, so your future income may do so as well. However, it does allow you to benefit from future increases in the stock market and you can manage your cash flow better because you only draw the income when you need it.
How much do they pay?
This all depends on the size of your pension pot and how well the pension fund performs as you take income out of it. Your income could rise if the markets do well, but fall if they do badly as could your remaining capital, therefore leaving you with a smaller “pot” than you originally had a available when the time comes to take an annuity.
Where can I get one?
Income drawdown is a complex area and we recommend that you speak to an Independent Financial Adviser specialising in this area who will be able to tell you more about the different variations of drawdown products that are available in the market place and whether they are suited to you.
If, having read this blog, you’re still not sure which option is the best for you, then please call Marchwood IFA now and ask us to review your pension arrangements. We can help you make the right decisions to help you achieve your retirement goals.