The Pensions Crossroad
Autumn 2007
How you draw income from your pension plan is one of the most crucial choices you can make about your retirement. The difference between making the right decision and the wrong decision can be the difference between a comfortable retirement and "getting by". There is now a wide range of options, thanks partly to the pension tax changes introdced in April 2006. In practice, two routes are dominant: annuities and income drawdown.
Annuities.
The pension annuity is the traditional way of converting a pension fund into regular income. It has great virtue of providing payments throughout your life - however long that might be. These payments are guaranteed, unless you choose an investment-linked annuity.
The annuity market is fiercely competitive, but its elements can vary from those in the pension plan market. A good pension plan provider may only offer poor annuity rates, making it very important that you do not accept what your provider offers without first checking with us what is available elsewhere. Industry figures (HM Treasury "the annuities market" Dec 2006) suggest that by shopping around you may be able to improve your pension by as much as 30%.
There have been a number of innovations in the annuity market over recent years, one of the most significant being the spread of enhanced annuities. These may offer you higher rates if your health or lifestyle is less than 100% perfect. For example if you are a smoker or have diabetes, you could qualify for a better annuity rate.
Income Drawdown
Income Drawdown, a form of unsecured income, is generally a higher risk strategy than buying an annuity and on the whole is only suitable for those with a range of other sources of retirement income. As the name suggests, under income drawdown your retirement consists of taking withdrawals - regular or one-off from your pension fund. HM Revenue and Customs (HMRC) sets a maximum withdrawal level and requires that withdrawals stop by age 75, at which point you must either buy an anniuty or switch to an "alternatively secured pension".
Income withdrawals have a number of advantages of annuities to set against the greater risk:
- If you die before age 75, the value of your remaining fund could be paid out as a lump sum. This is subject to a 35% income tax charge, but normally inheritance tax will not apply. Alternatively, the full value of the fund could be used to provide an income for your dependants.
- You could vary the withdrawals you take each year from nothing to about 120% of what a standard annuity would give you.
- You do not have to make up-front decisions about dependant's benefits. In contrast, if you make the annuity choice, if you make the annuity choice you have to buy the dependants' benefits at the time you set up the annuity.
- You could continue to control where you money is envested and you are not tied to the fixed interest investments that underpin traditional annuities.
Some income drawdown providers now offer an income guarantee, which has created an interesting halfway house between the annuity and the full risk income drawdown.
But all this extra flexibility and control comes at a price. Running an income withdrawal arrangement costs more. In particular, it involves more risk because the value of your investments can go down as well as up. As a result, the income may turn out to be lower than a comparable annuity, especially as, unlike annuities, there is no cross subsidy from people who die prematurely to those who live longer than average. If you start drawing a high income, it might not be sustainable if the investments do not perform. What is more, you could end up regretting not buying an annuity earlier if the rates continue to become more expensive.
So there are pros and cons to both annuities and income withdrawal. Our role is to help you decide on the most appropriate route for you.
