For many years the only way to draw an income from your pension pot on reaching retirement was to purchase an annuity. However, the landscape has changed considerably in recent years and an annuity is not the only option. Here is a brief guide to the options available to you.
Fixed or secure income otherwise known as an annuity
An annuity is still the most common way of taking an income but it does have both its advantages and drawbacks.
A lifetime annuity guarantees to pay you an income for the rest of your life in return for you giving the provider a sum of money. Annuities are offered by the big insurers and a couple of specialist retirement companies. They are known as a secure fixed income because they guarantee to pay you an income for the rest of your life. There are options that can be added to them, such as inflation linking, spouses’ benefits and guarantees, but they are pretty straightforward.
The advantage of them is that the income received is secure and, once you have purchased your annuity, you know exactly what you are getting every year and you don’t need to think about it again. If you smoke, drink heavily or have health issues, you could get a higher income as the provider assumes that you won’t live as long as someone who is healthy and doesn’t smoke or drink. The great advantage is that if you live until you are 110, you will not run out of income.
The disadvantage of an annuity is that if you die early into your retirement, other than some income guarantees, that whole fund is lost and it can’t be passed to your family. The other problem is that if interest rates are very low, like they are currently, when you retire, you will lock yourself into a poor income for the rest of your life.
Once an annuity is taken out, it can’t be changed and your family don’t get a refund if you die young. Your money goes into a pool and the people who die young fund the people who live a long time. The income that you receive from your annuity is taxable in the same way as your earned income was.
It is essential that you compare annuity providers on retirement and don’t just take the annuity offered to you by the provider that you have your pension with. The difference between getting a quote on the open market and taking the annuity offered by your provider can be significant.
Unsecured income or drawdown
This method of taking income from a pension was introduced around 10 years ago and is fast becoming a popular method for those with larger pension funds who are happy to accept risk. This method gives far more flexibility than an annuity in return for accepting risk to your pension fund.
Rather than purchasing an annuity, the fund stays invested and you are able to draw chunks of your pension out as an income, hence the term drawdown (drawing down). The idea being that, because the money is still invested, the fund has the potential to grow.
You can either take a prescribed level of income, which is driven by legal allowances, or for those who already have an annual pension income of at least £20,000, it is possible to draw out the whole fund or larger chunks subject to tax.
The income that you are taking is reviewed every three years, and if either interest rates and / or your fund value have increased, you will get a higher income. Of course the reverse is also true, if interest rates and fund values have fallen, or the government tinker with the amount you are allowed to withdraw, you could find yourself with a much-reduced income. This has happened to people currently using this method.
Living longer is a risk when using this method of funding your retirement as you could potentially run out of pension fund to buy you an income. This is a particular risk if you have been taking high levels of income or investment performance is bad. However, if you die early into your retirement, your fund can be passed to your beneficiaries, subject to a hefty tax charge, but at least they get something. There is much flexibility and many options available for taking your income this way, but it is not an option for the cautious or the risk averse. The income that you receive is taxed in the same way as your earned income was however there are planning options that can significantly reduce the tax you pay.
As always, good financial advice is essential. If you would like further information or advice, please contact me on 020 7125 0409
The Financial Conduct Authority does not regulate tax advice