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Small & big pension pots – do annuities beat drawdown?

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This content is for information purposes only and should not be taken as financial advice. Every effort has been made to ensure the information is correct and up-to-date at the time of writing. For personalised and regulated advice regarding your situation, please consult an independent financial adviser here at Castlegate in Grantham, Lincoln or other local offices.

Since the 2015 Pension Freedoms, over-55s have had more choice about how to use their hard-earned pension savings. However, without careful planning, this also presents a higher chance of making costly mistakes. In particular, a difficult choice often needs to be made between using the money for buying an annuity or for income drawdown.

In this article, our financial planning team at Castlegate in Grantham, Lincolnshire outlines some of the main differences between the two – and whether their suitability depends on the size of the pension pot. We hope you find this content helpful. If you want to discuss your own financial plan please get in touch to arrange a no-obligation financial consultation, at our expense:

01476 855 585

Annuities & drawdown explained

An annuity is a financial product – often bought from an insurance company – which provides you with a guaranteed retirement income, usually for life. Drawdown, on the other hand, involves taking money gradually from your pension pot(s) whilst keeping the rest invested.

The suitability of each option depends very much on your financial goals, your investment risk tolerance, how much you have saved, your desired retirement lifestyle and your personal health. An annuity usually provides a more stable, predictable income. However, income drawdown in 2021 is likely to provide a higher level of income – even if this likely fluctuates with the performance of your investments. Income drawdown also offers increased flexibility.

Why annuities have fallen

Buying an annuity – prior to the 2015 Pension Freedoms – used to be your only option for your pension pot(s). In 2021, however, annuity rates have fallen significantly. This is mainly because the Bank of England (BoE) has lowered interest rates to an historic low, at 0.10%. This lowers the returns for insurance companies which offer annuities, since they tend to invest the money (from pensioners) into “lower-risk” assets such as UK government bonds (gilts). The returns of these investments are reduced by lower interest rates. The companies then need to pass this lower return onto customers in the form of lower annuity rates (to keep turning a profit).

In 2010, for instance, a “single life” annuity for a 65-year-old might pay £6,555 per annum if she invested £100,000. By 2020, however, the figure had fallen closer to £4,760. For this annuity to pay for itself, therefore, you would need to live 15 years in the first case, but 21 years in the second. Nonetheless, annuities remain attractive for many people – especially during uncertain times, such as those brought about by COVID-19. The security of a guaranteed lifetime income, even if lower, can be immensely reassuring.

The drawback of drawdown

Keeping your pension money invested whilst gradually withdrawing from it (income drawdown) has the advantage of offering the potential of a higher overall income, compared to annuities in 2021. To take an example (with many assumptions), a 65-year-old using £100,000 in this way might achieve £6,747 annual income until the age of 85, or £5,025 until the age of 95. However, herein lies a problem with this strategy; namely, that you could run out of money if you take too much, too quickly. The ‘sensible’ draw rate is around 4% p/a, to help reduce the risk of funds running out. There is also the possibility of future stock market crashes, which would likely reduce the value of your pension pot(s) and so affect how much income you can safely withdraw.

A halfway solution?

There is no “perfect” solution when it comes to determining how to use your pension pot(s) to generate a retirement income. One popular option, however, is to try and combine these two approaches to try and get the best of both worlds. For instance, you could buy an annuity with some of your savings and – combined with your state pension – use this to cover your expected essential living costs in retirement. The rest of your pot(s), then, could be used to fund more of your “luxury” expenses such as holidays, meals out and holidays. This gives you reassurance that your “core” costs will largely be covered, even during hard economic times. However, you can also enjoy the extra income from drawdown to cover discretionary spending.

Ultimately, your choice between annuity, income drawdown or some combination of the two will depend on your personal goals, circumstances and attitude to risk. For many people, the main priority in retirement is to simply not worry too much about money. This can cause them to lean towards an annuity, for the peace of mind it brings, even if their income may not be as high and they will have less flexibility. For others, however, they will be comfortable with their retirement income fluctuating and may want to retain control over their investments. Another advantage of drawdown is that you can pass down unused savings in your pension pots to loved ones as an inheritance, usually free from Inheritance Tax.

Conclusion & invitation

Pensions can feel intimidating and overwhelming, but you do not have to make these important decisions alone. A financial adviser can help you attain the best, most up-to-date information you need to make informed choices – giving you confidence as you enter retirement.

If you are interested in discussing your own financial plan or pension strategy with us, please get in touch to arrange a no-commitment financial consultation at our expense:

01476 855 585