There are two main options for pension savers who hit retirement – drawdowns (which allows them to choose how much income to take out and when) or annuities (the purchase of a set income for life). Each comes with pros and cons that must be carefully weighed before committing to a decision.
Below, Daniel Chaplow, wealth planner at Succession Wealth, shares his tips and considerations, with the premise that everyone’s situation is different and only professional, regulated advice can ensure choices that are in line with one’s long-term needs.
For Chaplow, the main benefit of annuities is they provide a guaranteed income for life, unaffected by investment market fluctuations. This means retirees cannot outlive their income and, even if stock markets crash or interest rates fluctuate, payments will stay the same.
This is true for fixed annuities, but if agreed upon at the time of purchase, annuities can be tailored to different needs, including an adjustable income that increases annually by a set percentage or in line with the retail price index (a measure of inflation).
Additional annuity options include guarantees to ensure the annuity continues to be paid to beneficiaries within a specified period after death (through a guaranteed minimum payment period) or an income for one’s dependents in case of death.
For those that qualify, enhanced annuities pay out at a higher rate than standard annuities and can usually be accessed by people with particular health or lifestyle issues.
“The options you choose will affect the amount of income you receive, however. More guarantees typically mean a lower income,” Chaplow pointed out.
“Additionally, annuity rates tend to be lower when interest rates fall, potentially resulting in less income than expected. The income is generally fixed and cannot be adjusted, so if your circumstances change, you may need to find other sources to supplement your income.”
Other things to keep in mind are that the income received over the personal allowance is taxable and may change based on their income tax rate, inheritance tax may apply in some circumstances and income payments may be lower than the original amount of the pension pot used to buy the annuity.
A popular alternative to annuities is drawdowns, which offer greater flexibility and control over how the money is managed. Pension owners can leave their money invested and withdraw from it whenever they want.
Typically, they can take a tax-free lump sum of up to 25%, either immediately or in stages, and then make withdrawals as needed, Chaplow explained.
“This allows you to decide how and when to draw your pension savings. If your investment growth exceeds your withdrawals, you may increase your future income or leave a larger inheritance,” he said.
The main downside of drawdown is the long-term management.
“If you withdraw too much too soon or if your investments don't perform well, you may not have enough left to provide an income throughout your retirement. Unlike an annuity, there is no guaranteed income.”
To minimise this risk, the drawdown pension can be left as cash, which won’t be subject to any falls in the stock market but won’t benefit from any rises either. This might be a sensible option for those planning to spend all of their money over a short space of time, before inflation eats away at the cash returns.
“To choose drawdowns, you must understand how to invest your pension savings and how potential losses or gains might affect you in the future, as well as the tax implications of any withdrawals,” Chaplow said.
One does not exclude the other, however, and for many, “a combination of both drawdown and annuity may provide the best balance”.
As ever, rates may vary from provider to provider, so it is crucial to shop around when hitting pension age to benefit from the best deals available.