Recent regulatory changes to pension legislation have made Flexible Income Drawdown a viable option to many retirees who might have otherwise felt forced into buying an annuity.

This blog post outlines the differences between the two options and highlights the pros and cons of each. Please note this article does not constitute advice.

Under current legislation both options will allow retirees to access 25% of their pension pot as a ‘pension commencement tax free lump sum’, and for both options the income derived from the remaining 75% will be subject to income tax at marginal rates.

Annuity

Buying a standard annuity contract basically entails handing pension money to an annuity provider in exchange for a guaranteed income for life.

  • Pros:

• The income is secure and guaranteed for life. Even if a person lives to see 110 they will still be paid, and will probably have received great value for money from their pension pot.

• There are various options that can be included in an annuity contract to increase flexibility such as:
- a spousal / dependent’s benefit that will continue to pay a spouse or dependent an amount after death
- an annuity designed to increase as you get older – usually in line with an inflation index such as CPI
- a guaranteed period, which will ensure that your annuity will pay out a beneficiary for a set amount of time should you die within the guaranteed period (usually 5-10 years) or an element of capital protection.

An investment-linked annuity can be purchased if you would like to add some potential investment-linked upside to the annuity income.

• If a retiree has any health issues they may qualify for an enhanced annuity, which would mean a higher income awarded, depending on the severity of condition.

• Once an annuity has been purchased there is no further investment risk (aside from with an investment-linked annuity), and also as there isn’t a pot of money to manage anymore there are no annual management charges to pay – or decisions to make! For these reasons an annuity would normally better suit a more cautious investor with a low capacity for loss.

• Fixed-term annuities are available for those who wish to keep their options open. These contracts are designed to pay an income for a set number of years then will pay back a residual lump sum at end of the contracted term.

  • Cons:

• Once an annuity is purchased your pension money becomes property of the annuity provider, and unless you have a spousal benefit, guaranteed option, or some capital protection, your beneficiaries will receive nothing upon your death. If you die young you will probably have received poor value for money from your pension pot.

• There is currently no scope for varying someone’s annuity income should their circumstances change (except with an investment-linked annuity), hence they are quite inflexible, although this is due to change from April 2015.

• The additional annuity options mentioned in the ‘Pros’ section all have a cost and will all effectively reduce the amount of income received.

• Annuity rates are determined in part by prevailing interest rates and gilt yields, and also by life expectancy figures. Quantitative easing along with the sustained low (0.5%) Bank of England base rate and increased life expectancy of the population have all combined to make current annuity rates look poor value on a historical basis.

Flexible Drawdown

To a large extent, entering a pension drawdown scheme is the polar opposite of purchasing an annuity. In simple terms the pension pot remains invested and a retiree gradually draws money from it to fund their retirement, or, as Steve Webb the Minister for Work & Pensions suggested, whip out the entire fund (less tax at the marginal rate) to buy a Lamborghini . . . probably not advisable.

  • Pros:

• Control over the pension investment is maintained; retirees can stay invested and have a wide choice of investments to choose from to suit their attitude to investment risk. Savings could benefit from another 20/30 years of investment growth.

• The level of income is adjustable; this might prove beneficial to people who have chosen to keep working during their retirement, or have fluctuating income from other sources. In these instances the pension income can be adapted so that it remains as tax efficient as possible. Obviously this facility is also beneficial to people who might need periodic access to lump sums for world cruises, home improvements or care costs.

• Drawdown keeps the options open: if after a few years a retiree decides drawdown isn’t for them and they need more security, they are free to purchase an annuity at any time.

• Any money left in a drawdown account after death can be inherited by its beneficiaries but was potentially subject to a 55% tax charge – the Chancellor has recently pledged to scrap this. This removal of the charge will therefore make drawdown schemes a useful tool for estate planning purposes.

  • Cons:

• Unlike an annuity, a drawdown contract offers no inherent guarantees. Pension savings will fluctuate with the stock and bond markets, and poor investment performance or high levels of income could deplete pension funds quickly. There is a very real possibility that your pension pot could run out before you die, especially if you live a long time. Some pension providers offer the option to buy a guarantee for the amount of the initial pension capital, or the income to be taken from it; these options may become increasingly popular as a halfway-house between drawdown and annuities.

• The aforementioned risk of running out of money would potentially make a drawdown contract more suited to those with a higher attitude to risk and/or high capacity for loss, or where the amount of the pension pot is a relatively small party of someone’s overall wealth.

• A drawdown contract needs careful on-going management (as the regulators advise) to try and ensure that the pension doesn’t run out half-way through retirement. This advice is likely to incur regular charges.

Conclusion

The decision between purchasing an annuity and choosing pension drawdown is a complicated one, and will depend very much on personal circumstances and attitude to risk. Hopefully the above information will have given you an outline of the major differences between the two, but we would certainly advise seeking professional financial advice before you choose.

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