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What’s the best way to generate a retirement income? Broadly speaking, there are two primary options. You can buy an annuity – a financial product which provides a guaranteed income for life. The other option is income drawdown, which involves keeping your pension invested whilst withdrawing gradually from it to fund your lifestyle.
Alternatively, it is possible to combine these two approaches; e.g. using an annuity to cover your essential costs, and income drawdown to fund your discretionary spending. Below, our financial planning team at WMM outlines the pros and cons of both options and how they might be suitable for a retirement plan.
A closer look at annuities
Annuities can hold instant appeal because they offer a sense of stability in retirement. Here, you know how much income you will get each month, and do not need to worry about running out of money (provided you keep within your monthly budget). Many annuities can also link your income to inflation. This helps to retain your spending power as the cost of living rises over time. A joint annuity, moreover, can offer an income to your partner on death.
However, annuities are highly impacted by interest rates. Generally speaking, the higher interest rates are, the better the annuity deals available on the market. In 2022, interest rates are still at an historic low (0.5%). In short, you need a bigger lump sum to “buy” the same income from an annuity compared to, say, the 1970s – when rates reached as high as 17%. Annuities are also less flexible than drawdown, since you cannot alter the income once you’ve bought a product – or switch provider. Finally, you cannot pass down a pension pot to your beneficiaries (unless you purchase protection at the very beginning, and here your lifespan will affect the payments).
Income drawdown, compared
Individuals are no longer forced into the irrevocable decision of buying an annuity. With a drawdown plan, you can choose to keep this invested and take some of it out gradually to live on. With income drawdown, therefore, it is possible for your pension pot to continue growing even as you make withdrawals from it. There is also greater flexibility, since you can alter how much you take out, between zero and 100% (although this could of course have big tax consequences!). You could even use some of the money later to buy an annuity if you wanted to! Also, under current UK pension rules your pension pots fall outside of your estate for IHT (inheritance tax) purposes. This means that you could pass any remaining funds down to your beneficiaries, tax-free (unless you die after age 75; in which case, the money they withdraw will be added to their income tax bill).
The downside to income drawdown, however, is that there are no guarantees unlike an annuity. If you take too much from your pension(s) too quickly, then you could run out of money in retirement. Your pension will almost certainly be invested, at least in part, in the stock market, where the values will fluctuate daily, and the value could fall sharply. This will likely affect how much you can safely take out each month to fund your lifestyle, meaning there is less financial stability. There is also more management involved with income drawdown, since you must keep on top of your investments and make sure your portfolio continues to reflect your financial goals, your risk tolerance and of course your expenditure.
There is no “one-size-fits-all” answer to whether annuities or income drawdown are better in 2022. Indeed, as mentioned, sometimes individuals like to combine the two approaches to try and achieve the best of both worlds. A financial planner can help you survey your choice of options and come to a decision based on your goals, situation and the best information.
Interested in finding out how we can optimise your financial plan and investment strategy? Get in touch today to arrange a free, no-commitment consultation with a member of our team here at WMM.
You can call us on 01869 331469