How Do the New Pension Freedoms Affect My Pension?
Before pension freedom, most people were required to buy an annuity with their pension pot. An annuity offers a guaranteed pension income for life, so requiring pensioners to purchase them was one way to ensure retirees didn’t exhaust their retirement savings too early.
Income drawdown – where you invest your pension pot and take an income from it – was only previously available to those with guaranteed, non-drawdown income of at least £12,000 a year.
Now this restriction has been lifted, anyone aged 55 or over can take advantage of pension drawdown to provide a retirement income if they want to.
It is important to not that just because income drawdown is now available to anyone it doesn’t mean it’s automatically the right option for everyone.
Whether or not drawdown is better than an annuity for you personally will depend entirely on your individual circumstances.
What is an Annuity?
An annuity is a contract between you and a life insurance company. In exchange for your retirement savings, the insurance company promises to pay you a regular income until your death.
Annuities are irreversible. Once you’ve bought an annuity, you can’t alter the benefits you receive, get your money back, switch annuity providers to get a better rate or swap it for another type of annuity.
Are annuities a bad deal?
Annuities have had a great deal of bad press recently. Rising longevity means that annuity companies have cut the rates on offer to compensate for the fact that pensioners are living longer and therefore drawing on annuity income for an extended period.
Poor investment returns due to the rocky economic climate since the financial crisis (and, more recently, the Brexit vote), have exacerbated the issue.
The recent decision by the Bank of England to cut the base rate yet further, to a historic low of 0.25% after the Brexit vote, has yet further hit annuity rates.
This comes at a time where the new pension freedoms mean no one is required to buy an annuity anymore, resulting in a slump in sales.
Remember, although annuity rates may be low at the moment, it’s worth considering that an annuity offers a guaranteed income for the rest of your life. That’s not something that’s promised by income drawdown.
As people live longer than ever before, the promise of a lifelong retirement income from an annuity is looking increasingly valuable.
Pensions & Investments Specialist at Drewberry
Different Types of Annuity
Although the terms of annuities are fixed and you can’t change them, there are a number of variables you can apply to an annuity to ensure it’s as close a fit to your needs as possible from the outset.
What is a Single Life Annuity?
A single life annuity pays you an income for life until you die. That’s fine if you have no dependants, or perhaps your partner has their own pension arrangement and isn’t reliant on you.
If, however, you need your pension payments to continue after your death to a spouse or dependent children, then you have two options available to you: an annuity with a guarantee period or a joint annuity.
A guarantee period is a set length of time your annuity will continue paying out after your death.
So if you buy an annuity with a five year guarantee period and die after only receiving your annuity for one year, it will continue to be paid to your selected beneficiary for a further four years.
However, if you outlive your annuity guarantee period, then your beneficiary won’t receive anything after your death. Also, a guarantee period won’t provide your spouse with an income for the rest of their life – only however long is left on the guarantee period.
What is a joint life annuity?
A joint annuity – sometimes known as a spouse’s pension or a widow’s pension – also provides you with an income for life. However, on your death, a joint life annuity then transfers to a named beneficiary for the rest of their life. This might be your spouse, partner or a dependent child (although a dependent child can only usually receive income from a deceased parent’s joint annuity until they’re a maximum age of 23).
When you buy a joint annuity, you have to decide the proportion of your annual income your beneficiary will receive, e.g. half or two-thirds.
The higher this sum, the lower the initial payment will be to you while you’re still alive. Initial annual benefits for joint life annuities will almost always be lower than for single annuities, because insurers anticipate having to pay an income for longer.
What are Enhanced Annuities?
If you’re a smoker and/or retiring in poor health, then you might qualify for an enhanced annuity. These are also known as impaired life annuities and offer a higher annual retirement income than standard annuities to those who are ill.
As your ill health means you’re likely to be drawing on an annuity for a shorter time than a healthier person, insurers offer a higher annual benefit.
Should I Get a Level or Index-Linked Annuity?
A fixed annuity – also known as a level annuity or flat-rate annuity – pays you a set annual amount from the start of the contract until your death. However, this runs the danger that the purchasing power of your annuity income will be eroded over time by the effects of inflation.
To avoid this, you can choose to index-link your annual benefit by purchasing an escalating annuity. With these, the payment rises each year, either in line with inflation or by another fixed percentage agreed with your annuity provider.
The trade-off is that, because your annuity payments will rise over time, the amount you usually get to start off with is smaller than for a fixed annuity.
What is Flexi-Access Drawdown?
Pension income drawdown – known variously as adjustable income, flexi-access drawdown or flexible drawdown – involves drawing on your pension pot for an income as and when required.
How Does Income Drawdown Work?
You gain access to your entire pension pot from the age of 55 onwards. To move your pension into income drawdown, you move the cash from your pension pot and into an investment fund (or preferably funds) of your choosing.
Drewberry’s team of expert financial advisers and pension advisers are well-placed to guide you when it comes to making these investments to ensure you make the best investment decisions based on your attitude to risk and retirement income needs.
Do I Need to Transfer All of my Pension Pot into Income Drawdown?
No, and it will likely be beneficial not to. This is because you can withdraw an initial 25% of your pension pot tax-free, but if you wanted to shift your entire fund into drawdown at once, the remaining 75% of your pension savings will be subject to income tax at your highest marginal rate.
For this reason, many people choose not to move all of their pension pot into drawdown at once, as doing so would push them into a higher tax bracket.
Instead, they move their fund into drawdown gradually over a number of tax years. 25% of each transfer from their pot into drawdown is tax-free.
Although any cash you leave invested in your pension pot won’t provide you with an income, there is a chance for capital growth.
Is Pension Drawdown Better Than an Annuity?
Whether you should get an annuity or put your pension into drawdown will depend on your individual circumstances.
For those with smaller pension funds and little in the way of other assets to generate income, an annuity might place them in a better position to cope with any future reductions in income. This might be because drawdown investments underperform, or even because they run out, leaving the individual without any retirement income or anything to fall back on.
However, if you have a higher level of total assets then you are likely to be in a better position to cope with fluctuations in income as you can smooth it out with income from other source.
Can I Have an Annuity and Income Drawdown?
It doesn’t have to be a case of choosing either an annuity or drawdown. In fact, in many cases, a combination of both might be the most effective way of providing you with a retirement income.
For example, you might choose to buy an annuity to cover all your essential monthly living costs, such your food and housing costs, and then keep the remainder of your fund invested so you can use drawdown whenever you need extra income.
Should I Choose an Annuity?
What’s good about annuities?
- Annuities provide a secure income for the rest of your life. Even if you live to receive more in annual payments than you handed over to the insurer when you bought the annuity, the insurer must keep paying.
- As life expectancy rises, the promise of lifelong annuity payments becomes more attractive.
- An annuity involves no investment risk – your annual payments will never fall in turbulent markets and may even rise annually if you’ve index-linked your benefit.
- Annuities can provide a retirement income for a dependent spouse with no pension provisions of their own with a spouse’s/widow’s pension.
What are the drawbacks to annuities?
- Annuities can’t be changed if your circumstances change. Should the worst happen and you discover that you’re terminally ill after buying an annuity, there’s no way to get access to your original capital if you wanted to fulfil a ‘bucket list’, for example.
- You can’t adjust your income from an annuity in any way. Some people might want to reduce their income in any given year for tax reasons, or access more of their pension pot to help children, for instance.
- Annuities are offered on a cross-subsidised basis, so those people who die young are essentially subsidising the individuals who live longer. If you die earlier than expected you won’t have received the full value of your original pension fund back in annuity payments.
- Annuity rates have underwhelmed in recent years; you currently get far less for your pension pot than you would have done previously.
- Annuity rates fluctuate. If you buy an annuity now at today’s low rates and they then rise in the future, you’ll have missed out.
- Your income usually dies when you do, unless you have bought a joint life or guaranteed period annuity. However, both of these usually come at the cost of having a lower initial income.
Should I Choose Flexible Drawdown?
Is income drawdown better than an annuity?
- Flexi-access drawdown places no restrictions on what you can take from your pension, or when you can take it. Although you’ll always have to consider the tax implications, the cash it there to use as and when you see fit.
- With drawdown, your pension fund remains invested. This means your fund can continue to grow over time.
- Any funds remaining in your pension pot when you die can be passed on to your beneficiaries. If you die before the age of 75, this will be tax-free. Note that if you’re 75+ when you die, your beneficiaries may have to pay income tax on the unused funds they receive.
- Being able to leave your loved ones a lump sum rather than an annuity income might be particularly appealing if you want to leave pension funds to your children, who can’t generally inherit annuity income above the age of 23.
- There’s nothing to stop you changing your mind and buying an annuity later in life, whereas you can’t change your mind about your annuity purchase.
Disadvantages of pension drawdown
- The biggest risk when it comes to flexible drawdown is that your money might run out. If you overspend, your investments underperform or you live longer than expected, you may find yourself with no cash left – use Drewberry’s Pension Drawdown Calculator to help mitigate this risk.
- You pay income tax on cash you take out of your pension pot via drawdown just as you do on all other income, so taking a big lump sum could bump you up a tax bracket and land you with a hefty bill from HMRC.
- Leaving your pension fund invested means that the value can fall as well as rise in line with market fluctuations.
- You may have to pay charges each time you make a withdrawal.
Use our Pension Drawdown Calculator to check how long your pension will last if you fund your retirement through income drawdown.
There are pros and cons to both annuities and income drawdown, as are outlined above. That means choosing between the two is not a straightforward decision. Deciding how to take your pension income is a major financial decision with huge implications for your future quality of life. That’s why it’s recommended that you get financial advice before making any decisions.
The advisers here at Drewberry can discuss your options and aspirations and help you secure a retirement income that works for you.
Wealth and Investments Specialist at Drewberry
Need Pensions and Retirement Planning Advice?
If you’re about to retire and are trying to decide how you’re going to provide yourself with a pension, then it’s worth getting in touch with one of our specialist pensions advisers.
We’re available at firstname.lastname@example.org or, alternatively, you can give us a ring on 02084327333. We can help you get your pensions ducks in a row so you can retire in the style you deserve.