How to approach your biggest pension decision
A steady income for life or flexibility plus risk? Retirement options expert Billy Burrows weighs in to the debate over the two main pension options: an annuity or flexi-drawdown.
It’s the trickiest question of the age as far as personal finance is concerned: just what is the best way to use your pension savings? Pension freedom has given us all greater choice, but choice is only a good thing if you end up making the right one for you. Meanwhile the debate rages on over which of the two main retirement options is likely to be more successful. Who to believe?
The big either-or
Although there are a number of other possible options, the two main alternatives are an annuity or flexi-drawdown (usually called just ‘drawdown’). An annuity pays you a guaranteed income for life, while drawdown keeps your money invested so you can draw a flexible income from it for as long as the pot lasts.
In this series of articles I’ll be examining the key points of the debate – while showing you how you can cut through the noise and decide for yourself which solution will work best for you.
Annuities and drawdown: a side-by-side comparison
The chief advantage of an annuity is that you can’t outlive your income (and neither can your partner, if it’s a joint life annuity). The chief advantage of drawdown is that you decide how much income you need each month. You also keep control of your pension pot, which means that you can decide where it is invested and what happens to it after your death.
The main disadvantage of an annuity is being locked into the current level of low interest rates. Also, you cannot change the arrangement if your circumstances change. The main disadvantage of drawdown is that you could run out of income if you draw too much money from your pension pot, or if the pot does not grow in value as much as you expected.
Here are the key features of both so you can compare them at a glance:
Solving the riddle for yourself
It should be obvious by now that a straight comparison can’t really be done. For some people, the pros of one option will outweigh the cons, but for others they won’t. So perhaps a better way of addressing the question is to consider what you are trying to achieve with your pension fund. If your circumstances mean that you can’t afford to take risks, and you don’t want to be constantly reviewing the status of your pension pot, then the guaranteed income of an annuity might be best for you. Conversely, if you can foresee that you’ll need more flexibility, and the ability to increase your spending power at certain points of your retirement (perhaps to help out family) then drawdown could be the solution – if you’re also comfortable with the various associated risks.
In my opinion, the answer to the question ‘Which is better?’ will depend to a large extent on your particular circumstances, and can only be reliably answered by a regulated financial adviser. But if you want to start pondering the question yourself, my personal rules of thumb should help.
Billy’s rules of thumb:
- Most people underestimate how long they will live – and how much income they will need to live on.
- If you smoke, take prescription medication or have recently received medical attention you should apply for an enhanced annuity because you could get up to 40% higher income from an annuity.
- If you are considering drawdown, work out how much income you can take without running the risk of exhausting the fund prematurely. Many experts agree that about 4% of the fund value (increasing each year with inflation) should produce a sustainable income.
- Investing in drawdown differs from pre-retirement investing because of ‘sequence of returns risk’ (see below). One way to reduce this risk is to earmark the money to be used for income withdrawals and have it invested in cash or low-risk funds.
- As there is often a strong case for both annuities and drawdown, remember you can also consider a combination of the two.
Sequence of returns risk – what does it mean?
A bit of jargon perhaps, but an important bit to understand. Put simply, it’s a particular kind of risk you’re exposed to if you have a drawdown scheme. If equity prices fall soon after you start to take income from your invested pot, your pension fund may fall in value very quickly. It may then fail to recover sufficiently to make up for the early losses, so you may have to reduce your income in order to avoid running out of money. Talk to your financial adviser about this risk to make sure you understand what it could mean.
In my next article I’ll do some simple number crunching in order to try and answer the very important question: ‘Can you beat an annuity?’ Watch this space.
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Billy Burrows is an independent retirement options expert and industry commentator. Find out more at http://www.williamburrows.com