Helping You Understanding Pension Annuities and Drawdowns

Wednesday 3 July, 2024

What are pension annuities and pension drawdowns?

How do pension annuities and drawdowns work?

Are pension annuities and drawdowns right for you?

Mark White, Independent Financial Adviser (IFA), Chippenham discusses the options

When it comes to taking your pension at retirement, annuities and drawdowns are both well-liked options. They are in addition to your State Pension, which is based on your National Insurance contribution history and is separate from private pensions. Both pension annuities and pension drawdowns allow you to take 25% tax-free from your pension in one go. However, pension drawdown allows you to do it gradually if you wish.

What is a pension annuity?

A pension annuity converts the pension pot you have gathered throughout your life into an income for the rest of your life. In other words, your income is guaranteed so you know exactly how much you will receive and can budget accordingly.

You use your pension pot to buy an annuity. The annuity amount that you receive is based on numerous factors such as the size of your pension pot, your health, and the age at which you retire. You can decide whether you would like to receive a fixed amount each year, which can be paid either monthly, quarterly, half-yearly, or annually. Alternatively, you may choose to have the annuity increase at a set rate or rise in line with inflation.

The majority of annuities stop when you die. However, some annuities continue to provide an income for chosen beneficiaries until their death or allow you to build in value protection on your annuity. For example, if you paid £40k for an annuity but only got £20k back before you died, then the remaining £20k could be paid to a beneficiary. These annuity options, however, would reduce the income level of the annuity.

The different types of pension annuities are as follows:

  • Lifetime annuities are a standard annuity that guarantees you income for the rest of your life. A level annuity pays you the same amount until you die. An escalating annuity starts at a lower amount than a level annuity but rises at a set rate or with inflation.
  • Enhanced annuities take into account your health and lifestyle and could give you a higher income than a standard annuity. Also known as an impaired life annuity, it provides a higher regular sum because you are expected to have a shorter life expectancy.
  • Fixed-term annuities provide you with regular income for a fixed period, generally up to 25 years. A guaranteed maturity value will be available at the end of the term, which you can use to select another pension option.

Annuity rates are expressed as a percentage and determine how much annual income you will get from your annuity. Once you have bought your annuity, the rate you receive is locked in for the whole term, usually the rest of your life. This rate depends on numerous factors such as your age, when you buy the annuity, your health, the amount you deposit, and the options you select.

The most critical factor is interest rates. When interest rates go higher, you can usually expect annuity rates to rise with them. Conversely, when interest rates are at sustained lows, annuity rates will usually fall too.

The benefits of pension annuities include peace of mind, and the option to have an agreed guaranteed minimum payment period, useful if you want your annuity to continue to be paid to your dependents after your death. You can choose to fix your annuity or opt to have it linked to inflation. If you opt for an inflation-linked annuity, it will usually start at a lower amount. You can protect all or part of the amount of your pension pot used to buy the annuity, which means that when you die, a lump sum is paid to your dependents. Lastly, you can choose whether you want your payments to be monthly, quarterly, half-yearly, or yearly.

There are disadvantages, of course. The lack of flexibility if your circumstances change—you cannot change your retirement income. Unless you choose a specific additional option, if you die, the pension pot dies with you. Annuities are based on the average age that you might die, so if you die earlier, you receive less. Depending on the annuity rates offered to you, they may not provide the best value for money, and the options of indexing or a fixed sum at maturity can significantly reduce the income you could receive.

Mark White, Independent Financial Adviser (IFA), Chippenham said: 

“There are many annuity providers to choose from, and your financial adviser can compare each of their rates before helping you to make a final decision on one.”

Pension Drawdown

Pension drawdown allows you to leave your money invested and take an income from the pension as and when you need it. The benefit is that your pension pot remains invested and can grow even after money is taken out. Drawdown is also flexible; you can control when and how much you take money out, with either regular income payments or in lump sums.

Before April 2015, pension drawdown rules were highly restrictive. But the Pension Freedoms legislation introduced in 2015 gave individuals more choice in how to access their pension savings. Flexible access drawdown was also introduced in 2015.

When you reach 55 years old, rising to 57 in 2028, you can start a pension drawdown by taking money out of your pension. You have total control over how and when you choose to take your pension, either monthly, quarterly, annually, or in lump sums. Unlike the majority of annuities that stop when you die, these flexible pensions allow you to pass on your remaining pension pot as inheritance for your next of kin.

There are several benefits to pension drawdown. These include potential growth in the stock market even after you start to take your pension, complete flexibility, allowing you to choose exactly what you draw, and increase or decrease at any time, and the ability to pass your pension pot on as inheritance. If you already have another defined benefit pension or a source of income in retirement such as a buy-to-let property, a flexible drawdown may be better suited to you than a fixed income from an annuity.

There are drawbacks too, of course. If your investments perform poorly, you may need to reduce the income you take, and you will need to regularly review your investments to ensure that you are still on track.

Other options

There are other options when retiring. You could opt to buy short-term annuities or a series of fixed-term annuities that last between one year and twenty years. The benefit of these is that they are more flexible than regular annuities but still give you a regular income.

It is worth noting that you can only buy an annuity if you're aged 55 or over and if you have at least £5,000 available after you have taken any tax-free cash from your pension. 

Mark White, Independent Financial Adviser (IFA), Chippenham round up the options:

  • If you value certainty, an annuity could be a good option for you as it means you'll receive a stable income for the rest of your life that won't be affected by fluctuations such as those in the stock market. 
  • If you have poor health and there is a greater risk that you will die relatively early due to this, you could receive an enhanced annuity, which would give you a higher income.
  • You could choose to use an annuity and drawdown. Some of your pension purchases an annuity, and the rest is invested and used for drawdown. This option gives you both some certainty and flexibility.
  • Or you could wait to purchase an annuity later in life, giving you flexibility when you need it in early retirement and more certainty for later in life.

If you are unsure whether a pension annuity or a pension drawdown is for you and would like to discuss your options, please contact your local Lonsdale Financial Adviser in WimbledonBarnetLeeds / BradfordStafford,WareChippenhamRingwoodHarpenden, St Albans.

Please note: The value of your investment can fall as well as rise and is not guaranteed. The Financial Conduct Authority does not regulate Cashflow Modelling, Tax and Estate Planning. The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested.

A pension is a long-term investment. Your eventual income may depend on the size of the fund at retirement, future interest rates and tax legislation.

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