RETIREMENT OPTIONS COMPARISON
Annutiies and income drawdown offer very different paths into retirement and it can be difficult to make the right choice. Each option is attractive for different reasons. Here we provide a quick summary of the advantages and disadvantages of annuities and pension income drawdown.
- Simple, easy to understand
- Once set up income is fixed and secure
- The income will never run out, however long you live
- Available for pension funds of all sizes
- No ongoing reviews required
- No investment risk: not affected by stockmarket falls, or economic slumps
- Can be inflexible
- Cannot be changed once purchased
- An annuity (without value protection) cannot generally be passed on to your beneficiaries as a lump sum
- Current annuity rates are perceived to be low
- Spouse’s benefits must be set up at outset - so can be wasted on divorce or if spouse dies first
Pension Income drawdown
- You do not have to make a one-off decision
- You retain investment choice and control
- Can potentially pass pension on to beneficiaries (less 55% tax)
- More flexible
- You can plan the income you receive to match your requirements
- Potential for growth and increasing income
- More complex, you may need advice
- Requires regular reviews
- Can be expensive: may not be cost effective for smaller funds
- An annuity set up on day 1 may have offered a greater total income over lifetime
- High income withdrawals and/or poor investment performance can strip the fund bare
- The income and value of the fund can fall, and at worst the income could run out.
- There is no security of income.
More about the advantages and disadvantages
Pension income drawdown needs constant attention. Because pension drawdown is more complicated than the one off decision of buying an annuity, it is necessary to review your plan on a regular basis (at least once a year) to:
• check whether you are taking too much income out of your plan and reducing its value;
• see how your pension fund is progressing, including the investment strategy;
• find out how much your fund needs to grow to keep paying the income you want;
• consider your state of health as this may affect future decisions;
• decide whether you want to buy an annuity.
If you don’t keep a close eye on the above you run the risk of losing out financially. You also need to consider your spouse or partner. You may only spot that things are not going as well as you had expected when it is too late. You could miss out on buying an annuity when rates would have been better, or when the investment growth on your fund has been very good.
To help you keep an eye on your pension drawdown plan we will send you a review pack at least once a year, in addition to your three year review.
Conventional annuities on the other hand are a one-off decision. Once you have decided on the basis of your annuity and it is set up the income will be paid into your bank account for the rest of your life. You have no other decisions to make and can get on with enjoying your retirement.
Pension Drawdown is more flexible. If you look at the last point from another angle, opting for pension drawdown is not a final decision in the same way as buying an annuity. Once a conventional annuity is purchased it cannot be altered, and you have no influence over the income. Under pension drawdown the income is flexible, in that the level and frequency can be varied so long as it stays below the annual maximum. This allows you to vary your income either for tax planning, or to take other income into account.
The death benefits of pension drawdown give far more scope to allow for changing circumstances. For example, you may buy a spouse’s pension as part of your annuity and then not require it if you get divorced or your spouse dies before you.
With pension drawdown, you are able to adjust your retirement strategy as your circumstances change.
Annuities are less expensive. When you buy an annuity any set up costs and ongoing charges are included in the rate you receive. You will not be charged any more and will simply receive your income when it is due.
Pension drawdown are different and charges for ongoing administration and investment management will be deducted from your drawdown account. The extra flexibility has a cost. These charges will prove a drain on your pension fund and you will need extra fund growth to make up for them. Make sure you take account of these extra costs in your expectations. Charges are taken into account in the figure called the ‘critical yield’ (this will be shown on your illustration).
Last, but not least, if you have gone into pension drawdown you can always buy an annuity later on. Once you buy an annuity you cannot reverse this decision.
Finally, do not forget to take the cost of any financial advice into account.
Other factors to consider
Current annuity rates are low - but may not increase. Annuity rates have fallen over the last decade and despite an increase over the last two years, are starting to fall again. Many people perceive annuities to be poor value because rates are low. Despite current low rates there is no guarantee that annuity rates will rise in the future, even if you are several years older. One of the key factors influencing this is increasing life expectancy. As people are on average living longer, annuities have to be paid for longer, and rates have been gradually going down. The lower the annuity rate, the lower your income.
Proposed future changes to the cash reserves annuity companies are required to hold could also bring down annuity rates. The other major factor affecting annuity rates is long term interest rates. These are low at the moment. We believe annuity rates are unlikely to increase significantly in the foreseeable future. If they do fall further then buying an annuity at a later date may not be such good value for money.
Mortality drag and cross subsidy
With annuities, there is a general misconception that when you die the insurance company pockets all your hard earned money. In fact, annuities work on a principle of cross subsidy. Put simply, with annuities the people who die earlier than expected “subsidise” those who live longer. In any one group of people buying their annuity at the same time, some of the people will die in the early years – and subsidise the rest. Pension drawdown does not have this cross subsidy as your drawdown account is exclusive to you. If you delay purchasing an annuity in favour of income drawdown, when you eventually buy your annuity you have lost out on the cross subsidy of those who have already died. To compensate, the investments have to work harder to catch up. This is “mortality drag” and is a term often used when comparing income drawdown to an annuity.
Using drawdown to delay buying an annuity in the hope that rates will get better is a high risk strategy and you may not end up with the result you are looking for. You also need to bear in mind that the longer you delay setting up an annuity, the longer you have to wait before your annuity starts generating an income. If you think you are likely to live longer than average, then an annuity may well be worth considering.
If your total pension savings are less than 1% of the Lifetime Allowance (currently £1.8 million therefore the triviality threshold is £18,000), you may be able to take them as a lump sum. This total usually includes all pension savings and the deemed value of pensions in payment, excluding any state pensions. There are a number of rules that apply including:
- you must be over 60 years;
- any trivial benefits must be taken within one 12 month period;
- at least 75% of the payment would be subject to income tax.
A trivial payment from an occupational pension scheme could be paid separately under different rules. If you fall into this category pension drawdown is very unlikely to be a consideration.
In our view, income drawdown is a consideration if one or more of the following apply:
• You can afford for the income drawn from your pension fund to fall, possibly significantly.
• You have sufficient income or capital outside the drawdown plan, making it only a small part of your total retirement income.
• The more flexible death benefits are important to you.
• You are happy to take a higher risk strategy with your pension benefits.
• You want your pension fund to remain invested as you believe that markets will improve faster than annuity rates will decline.
• The tax planning and income flexibility of drawdown is an essential part of your financial planning.