Which is Better Pension Drawdown or Annuity?
By Becky Barnet: Reading Time 6 Minutes
Which is the Best Option For Your Retirement?
With figures showing a spike in the number of people retiring over the next five years, more and more people are going to be faced with a difficult decision at retirement – how to make the most of the pension fund they’ve accumulated during their working life.
For the ever decreasing number of people in final salary schemes the decision is already made, with the income you receive dependent on the number of years you’ve worked and your final salary.
Most people, though, are now in less attractive money-purchase schemes – where the amount of your pension depends on how much you (and hopefully your employer) have invested throughout your working life, and how well your investments have performed. You could have devised a suitable retirement plan for yourself if you had consulted a reputable financial advisor (click this Infographic: Benefits of Fee Only Financial Planners for more information on them) at an early age.
Deciding what to do with your pension “pot” at retirement is one of the most important financial decisions you’ll ever make.
For most people it comes down to a choice between taking an annuity – an income for the rest of your life – or income drawdown: keeping your money invested and drawing it as needed.
Independent Financial Advice is absolutely vital when you make this decision, but here’s a snapshot guide to the two different options – and the pros and cons of each.
Taking an Annuity
Note – with an enhanced annuity a medical may be required
Figures from the Association of British Insurers reveal that 353,000 annuities worth 11.9 billion were sold last year to people converting their pension pot into an income, a significant 16% drop on the 420,000 sold the year before.
Despite these figures – most people end up buying an annuity at retirement. Why? Because most people have relatively small pension pots (the average pension fund size is around 20,000).
That’s the first important point – if your pension is relatively small (anything up to 100,000) then you’re probably better off with an annuity
Most advisers will argue that below 100,000 you don’t have the money to justify the cost – and potential risks of income drawdown. So what are the advantages of an annuity?
It’s predictable. On the day you buy your annuity you know what your income will be for the rest of your life. There are a wide variety of options (and your financial adviser will guide you through them) but once you’ve made the decision, that’s it. You know what your income is going to be and you can plan accordingly.
The money will never run out. Under an annuity your income is guaranteed to be paid as long as you live. Even if you ‘beat the odds’ and live to 100, your income will still be paid.
You can provide for your spouse. Among the options available when you choose your annuity there’ll be the chance to provide an income for your spouse or partner if you die first. This could reduce the amount of money you’ll initially receive, but the option is there – again, your financial adviser will explain all the options.
But an annuity also comes with disadvantages…
Annuity rates are low. With bank base rate at 0.5% and the Bank of England seemingly committed to keeping interest rates low, annuity rates have gradually come down. Factor in the increase in life expectancy over the past twenty years and many people are surprised and disappointed by how little income they receive when they buy an annuity.
The income isn’t flexible. As we noted above, once you buy an annuity, that’s it, the income is fixed. If your financial circumstances change, an annuity can’t change with them.
Too many people stick with their existing pension provider. Just because you’ve built up your pension with Company XYZ doesn’t mean you have to buy your annuity from them. Virtually all pensions now come with the ‘Open Market Option’ meaning you can buy an annuity from a different company in order to get a better income.
Again, your financial adviser will explain this: it will almost certainly be to your advantage to explore this option.
Clearly an annuity won’t be right for everyone – so is income drawdown the answer? This involves leaving your pension fund invested and drawing a regular income from it by cashing in some of your investments – which brings with it advantages and, of course, disadvantages…
Pension Income drawdown is flexible. It offers you the chance to vary your income as you need it, meaning that you can manage your cash flow better.
You can benefit from stock market growth. With most of your money remaining invested, this means you will benefit if the funds in which you are invested do well.
Pension drawdown can be helpful for estate planning (passing on an inheritance). For instance, by phasing drawdown, you can potentially reduce your exposure to inheritance tax in the event of your death before reaching 75 years of age.
Pension drawdown allows you to make changes as your circumstances change.
The reverse has to be true: the funds in which you are invested can do well, but they can also perform poorly. That could mean that you can’t receive the income you need from your drawdown arrangement.
Income drawdown is more expensive. Fees and charges on an investment drawdown arrangement can be quite high, which is why many advisers suggest you need at least 100,000 to make it worthwhile.
The money can run out. This is the nightmare scenario for many pensioners. Theoretically you could end up ‘living too long,’ especially if you have suffered from poor investment performance. As we saw above, with a conventional annuity this can never happen.
So both annuities and pension drawdown have significant advantages and disadvantages. However one thing is for certain – if you have a money purchase pension you will at some point need to choose between them.
Arranging your Pension options tax efficiently can make a significant difference to your returns over the long term, and we’re obviously happy to talk to you about how you can do this.
As always – we are only a phone call or an e-mail away.
The London Investor
The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. The Financial Conduct Authority does not regulate tax advice.