The end of working life leads to one of the greatest choices a saver car face: how to gain an income in addition to the state pension. There are essentially two mainstream routes available: annuity and pension drawdown.
An annuity is a regular guaranteed income, either for life or a fixed number of years, usually purchased from an insurance company. It is, in a sense, an insurance against living too long. While annuities offer the safety of a guaranteed income, this option lacks flexibility as it cannot be changed at a later point to reflect changes in personal circumstances.
In comparison, pension drawdown (also known as flexible retirement or flexi-access drawdown) is about taking out a portion of the money in a pension pot after retiring. New retirees can withdraw up to 25% of their pension pot as a tax-free lump sum and leave the remaining invested. It is then up to the individual to decide whether they want a regular income or to draw an amount whenever they need it. As money stays invested, potential gains depend on the market and can instead lead to losses.
Annuities have not offered value for money in the past decade due to the low interest rates environment and the introduction of pension flexibility for drawdown pensions in the 2014 Budget.
Jessica Ayres, chartered financial adviser at Timothy James & Partners (TJP), said: “Since interest rates declined following the financial crisis, annuity rates fell steadily from a high of 7.9% in 2008 to 4.7% in September 2016 (based on a £100k fund, aged 65 and single life).
“You may have considered 4.7% acceptable given the guaranteed level of incomem however this would be eroded by inflation and provides no spouses benefits or the ability to pass onto dependents. It is a one-off decision, fixed for life with no flexibility.”
Ayres added that TJP discounted annuities as a viable retirement option for its clients until recently, but the recent rapid rise in interest rates has made annuities attractive again.
She said: “This must have been reflected across the industry, as when transacting our first piece of annuity business this year, we were met by severe under resourcing in annuity departments and turnarounds for quotes was up to 20 working days.”
Does the resurgence of annuities mean that it is the right retirement income option for everybody? It would rather depend on individual circumstances.
David Lamb, director of Lamb Financial, said: ”Using cashflow modelling to understand what a client’s lifestyle looks like through retirement is essential. What do the clients want to do in their active phase, and how much is this going to cost? How much will they need to comfortably support the traditional phase?
”What guaranteed income do they have? Obviously, the state pension, but are there any defined benefit schemes? Does this income cover their expenditure in traditional retirement? If so, the client may want to consider drawing down all the defined benefit schemes to fully maximise active retirement?”
Lamb suggested to purchase an annuity from age 70-75 if somebody does not have enough to fund the traditional retirement phase.
But again, lifestyle, attitude to risk and objectives play a determining role in the decision of whether and when to purchase an annuity.
Lamb added: “Some clients are very risk averse, with no great ambitions during active retirement, and these will feel more comfortable with an annuity.
“The current relatively high interest rates obviously make annuities more attractive, but our experience suggests that it is the other features of annuities that clients still consider priorities. The more favourable rates just mean that the insurance policy against living too long is cheaper.”
Yet, there is nothing preventing individuals to blend different options.
Ayres said that people with a large enough pension pot might want to combine flexi-access drawdown with annuity income.
She added: “To do this, I calculate a clients guaranteed income (state pension, workplace annuities etc) and secure income sources (rental income etc) and see how much of their expenditure is covered.
“If secure income sources are low, then building in a portion of annuitised income may be attractive to the client. Cashflow modelling will build in the long-term effects of inflation.”
For Robin Melley, managing director of Matrix Capital Limited, retirement income should also be a blend of the different options available.
He said: “Often the solution is a combination of approaches, including income drawdown, amortising capital held in less tax-efficient wrappers, such as ISA and GIA (particularly where there is an IHT liability) and annuities (both compulsory and purchased life).
“I do not have a preference because it entirely depends upon a client’s circumstances; and in any event, it is not a binary option of an annuity versus drawdown.”
While annuities are offering value for money again, they remain, by nature, less flexible than pension drawdown and this can have an impact on the latter phase of retirement.
Melley added: “One of the key difficulties with recommending annuity instead of drawdown is that it reduces flexibility and choice later in retirement in circumstances where clients’ costs significantly increase as a result of one or both needing to fund either domiciliary or residential care.
“The shape of the cash flow from retirement to death is significantly different in 2023 compared with 30 years ago when I joined the profession. Consequently, people planning their retirement (and their advisers) should factor in that it is very likely that they will need to fund increasing costs of support and care in the latter years of their retirement.”