Client often ask us about whether to use their pension pot to buy an annuity or take the more modern approach of flexible access drawdown.
Buying an annuity results in a secure, guaranteed income for life.
It’s a financial instrument designed to exchange capital (the value of your pension pot, after taking any tax-free cash entitlement) with an income for the rest of your life.
You can add various options when purchasing an annuity, including indexation of the income (so it increases each year to keep pace with price inflation), a benefit for your spouse or civil partner in the event of your death before theirs, and a guarantee period where the annuity income will continue to be paid for the remainder of that term, say five or ten years from when you purchased the annuity.
Annuity purchase with a pension pot was historically the most popular choice.
However, the introduction of pension freedoms in April 2015 combined with rising life expectancy and falling gilt yields (government bonds are a commonly used investment made by insurance companies to secure annuity income, so when yields are lower, annuity rates tend to be lower too) and other factors made buying an annuity less attractive.
But what about income drawdown or, to give it the proper name, flexible access drawdown?
This retirement income option involves keeping your pension pot invested and drawing an income from that invested pension pot.
Doing this involves some elements of risk.
There’s the risk that the investments within your pension pot will fall in value. There’s also a risk that the amount you are withdrawing from your pension pot will be unsustainable, with the value of your pot declining over time and, in the worst case scenario, you running out of money before you die.
These risks mean that flexible access drawdown tends to suit best those who are prepared to and able to take investment risk.
It might be suitable for you if you have other sources of income or capital which you can use to cover your essential expenditure in retirement.
Flexible access drawdown is also more likely to appeal to those with previous investment experience, rather than novice investors who are unfamiliar with the volatility they are likely to experience.
There is still a useful role for annuity purchase as a retirement income option.
Despite relatively low annuity rates, buying an annuity is a good way to get financial peace of mind, which is especially important in later retirement when you are less likely to want to make important investment and financial decisions on a regular basis.
And of course you can always mix and match buying an annuity with flexible access drawdown; it doesn’t need to be an ‘either, or’ situation.
There’s a good argument for buying an annuity with part of your pension pot in order to secure essential expenditure in retirement, and then leaving the balance of your pension pot invested so you can use flexible access drawdown to cover additional spending.
Anyone who starts their retirement income strategy with flexible access drawdown should be reviewing the annuity purchase option at regular intervals, as there is likely to be a time when securing your income with an annuity purchase becomes more attractive than continuing with flexible access drawdown.
What really matters though is having a comprehensive financial plan in place that covers your goals in retirement.
Buying an annuity or using flexible access drawdown should never be considered in isolation. Instead, you should be factoring in your income, expenditure, assets and liabilities, modelling these through to the end of your life using reasonable assumptions about the future.
Do speak to us if you’re pondering this question of annuity purchase or income drawdown; we would love to chat with you about all of the things to consider.
