During your working life, your primary focus is likely building wealth for the future. Then, as you get closer to retirement age, it is time to start thinking about how you are going to utilise those savings to fund your lifestyle.
If you have a defined contribution (DC) pension, you may decide to transfer it into drawdown and take a regular income or lump sums instead. Alternatively, you could purchase an annuity that provides an income for either the rest of your life or a fixed length of time.
Some people also choose a combination of these options, perhaps purchasing an annuity with a portion of their pension funds to provide a base level of income and then transferring the rest into drawdown.
Since the introduction of Pension Freedoms in 2015, flexibly accessing a DC pension has become the favoured option for many.
Indeed, in its 2017 Retirement Outcomes Review, the Financial Conduct Authority (FCA) reported that 90% of pension pots were used to buy annuities before the introduction of Pension Freedoms on 5 April 2015.
Yet, between October 2015 and September 2016, twice as many pension pots had been transferred into drawdown than used to purchase annuities.
This may be because drawdown offers more flexibility over how you spend your retirement savings. You can also leave funds invested for longer and you may have more opportunities to pass wealth on to your loved ones.
However, whilst drawdown provides flexibility, this often comes at a price. Your monies will be exposed to the vagaries of the financial markets and there is a risk that your retirement funds will be fully depleted before you die. This means you will be reliant on your basic State Pension.
An annuity, on the other hand, provides the certainty of a guaranteed income.
This is one reason why there may be a renewed interest in annuities right now. Additionally, rates have risen considerably in recent years, potentially making them a more attractive option for your retirement.
Annuity rates have risen by 44% in 2 years
The past few years have been characterised by high inflation and rising living costs. In an attempt to control inflation and bring it down to its target of 2%, the Bank of England (BoE) raised the base rate 14 consecutive times – leaving the rate standing at 5.25% as of January 2024.
While this has caused increased borrowing costs for many people, it could be good news for those hoping to purchase an annuity.
When you buy an annuity, you exchange some or all your pension pot for a predetermined income which is guaranteed for a certain period, often the rest of your life. The level of income that you receive depends on several factors including your age, your health, where you live, and the rates offered by the provider.
These “annuity rates” vary depending on the insurer (so it is always beneficial to shop around for the best rate for your circumstances) and they are typically linked to interest rates.
This is because providers normally purchase government bonds to generate returns and pay an income to those who buy an annuity. So, when interest rates go up, they likely see a better return on those bonds and annuity rates increase as a result.
Indeed, in December 2023, MoneyWeek reported that annuity rates had increased by 44% in the past two years. In practice, this means that a 65-year-old with a £100,000 pension pot could earn £7,149 a year from an annuity, compared with just £4,953 two years before.
An annuity might not give you the flexibility you need
While the guaranteed nature of an annuity may feel attractive – you know what income you will receive every month – one of the key benefits of drawdown is that you have far more control over your savings. You are free to change the level of income you take from your pension savings and leave the rest invested.
An annuity, on the other hand, pays a set income each month. And, once you have bought an annuity there is normally no way of “undoing” this – meaning that if annuity rates rose again, or you needed to make changes to your income, you’d not generally be able to do this.
If you have a “fixed-term” annuity, you may be able to benefit from higher rates once the term comes to an end, if you purchase another annuity. However, you are not usually able to change the annuity rate before the end of the term.
The added flexibility of drawdown may be useful for several reasons. Firstly, it could help you mitigate Income Tax. You can draw on funds from other sources first, such as an ISA, and take a smaller income from your pension.
This may reduce the amount of taxable income you receive in a given financial year. As a result, you could pay less Income Tax.
Flexibility is also useful if you need to increase the amount that you draw from your pension due to a change in your expenses. For example, you may want to take a higher income to make big purchases such as a new car or a holiday.
It could be beneficial to make adjustments during a period of high inflation too. When costs are rising, you might need to increase your income to maintain your current standard of living.
Conversely, during periods of market uncertainty, using drawdown you can reduce the amount you take to protect the value of your fund, perhaps supplementing your income from cash or other sources.
While you can purchase an inflation-linked annuity, you normally have to take a smaller income to begin with, which then increases over time. This could mean making sacrifices to your lifestyle in retirement.
Ultimately, if you purchase an annuity, you don’t have the same flexibility over how and when you draw your retirement savings. This could make it more difficult to cover large one-off expenses if you don’t have other savings to pay for them. You might also find it harder to adapt to changing circumstances, such as inflation.
You could miss out on potential investment returns
Another great benefit of saving in a pension is that the funds are invested. This means you potentially see your wealth grow over time.
If you transfer your pension to drawdown and start taking an income, any funds left in your pension remain invested. As a result, you could benefit from further growth that might help your savings keep pace with the rising cost of living and maintain their real-terms value.
When you purchase an annuity, on the other hand, you may spend a significant portion of your pension savings – if not all of them – and your income is typically fixed unless you purchase an inflation-linked annuity.
While this does mean that you are no longer exposed to potential losses, you can’t benefit from any positive returns either.
It could be more difficult to pass wealth to your loved ones
Passing wealth to your loved ones may be an important part of your financial plan. If you purchase an annuity, this could be more difficult.
Depending on the type of annuity you buy, the payments may simply stop when you die. Your family could still inherit any remaining savings in your pension, but this might not be much if you spent a significant portion of your pension pot on the annuity.
However, there are certain types of annuities which may continue making payments after you die:
- Joint-life annuities – Your partner continues to receive an income after you die, at a reduced rate. You choose how much they receive and the higher the percentage, the lower your annual income will be while you’re alive.
- Guarantee periods – The payments are guaranteed for a certain period and if you die before this, your chosen beneficiaries still receive the payments until the end of the period. However, if you want to secure a longer guarantee period, you may have to reduce your annual income.
- Value protection – A value protection annuity returns the initial purchase price, minus any income you have received, to your chosen beneficiaries when you die. Again, you may have to reduce your income to benefit from value protection.
While these options can help you ensure that your loved ones receive some of your savings when you die, you normally have to sacrifice your own income to achieve this. There’s also a risk that you may pay in more than you and your family receive.
Conversely, if you transfer your pension into drawdown, you can typically pass all the remaining funds to your chosen beneficiary without triggering an Inheritance Tax (IHT) charge.
Bear in mind that in both cases, your beneficiaries may still pay Income Tax on any pension payments if you die after age 75.
Get in touch
If you need guidance, we can discuss the different ways to use your retirement savings and achieve your dream lifestyle.
Email hello@fcadvice.co.uk or call 0333 241 9900.
Please note
This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future results.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates and tax legislation may change in subsequent Finance Acts.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term (minimum of 5 years) and should fit in with your overall risk profile and financial circumstances.
The Financial Conduct Authority does not regulate estate planning, tax planning or will writing.
