Nico writes:
“I’m 53 and I’m starting to think about the best way to access my pension savings.
A friend said I should look at getting an annuity as I have high cholesterol and he said this might mean I get a better rate.
But I don’t understand what this means. I thought that nowadays I could just take money out of my pension whenever I need it, through drawdown. I’m confused!“
Faith Archer replies:
Don’t worry! There are two different ways you can access the money in your pension pot.
So yes, after reaching 55 (rising to 57 in 2028), you can indeed take your retirement savings out of your pension whenever you need them.
This is thanks to “pension freedoms” that the government introduced in 2015.
Taking your cash flexibly from a pension is known as “pension drawdown” or “income drawdown”, and applies to defined contribution schemes, which I assume is the type of pension you have.
The alternative, as suggested by your friend, is to use your pension pot to buy an annual income known as an “annuity”.
Read more: The best annuity rates in 2024
How an annuity works
With an annuity, you hand over the whole pension pot to an insurance company. In exchange they pay you a guaranteed income that will last for the rest of your life.
Annuities get a bad rap because the rates at which they exchange your life savings and turn them into an income stream are so low. The rate is determined by things like interest rates and competition among insurers.
And of course whether you get a good deal will depend on your individual circ*mstances and how long you live.
If you die ten years after you buy the annuity, you are very unlikely to have received all of your pension pot and the insurer will swallow the rest.
But if you live into your 90s or even past the big 100, an annuity may well have been a wise move as you end up receiving more than your original pension pot.
As your friend points out, annuity companies do pay a higher rate if they expect you to have a shorter life expectancy.
These annuities are known as “enhanced” or “impaired life”.
So you should get more cash if for example you are a smoker, overweight or suffer from a medical condition that might shorten your life, including diabetes, high blood pressure and high cholesterol.
But before you grab an annuity, take a look at drawdown. There are pros and cons to both. Let’s see how they battle it out in the retirement boxing ring.
Pros to pension drawdown
1. Pension freedom
Drawdown puts you in charge. You have the flexibility to take out as much money as you want, when you want. If you are still working after 55, you could take out smaller sums. If you retire early, you could bump up withdrawals until your state pension kicks in.
2. Investment growth
Your pension fund stays invested, so it could grow higher than inflation.
3. Flexible withdrawals
You can withdraw more – or less – retirement income than you’d get from an annuity, and change the amount whenever it suits you.
4. Avoid inheritance tax
If there’s any money left in your pension pot when you die, you can leave it to your nearest and dearest free from inheritance tax.
Cons to pension drawdown
1. The value of your savings can still fall
You keep your pension invested, meaning your pension pot remains in the hands of any stock market storms.
2. You could run out of money
This is especially true if you take out too much, too soon, or live longer than expected. Whipping out large lump sums could also push you into a higher tax bracket and land you with a bigger tax bill.
3. You need to manage your money
This means paying attention to where your money is invested, monitor investment performance and manage how much income you take. Or pay a professional to do it for you.
Do you want to deal with all that in later life?
Pros to pension annuities
1. Annuities provide peace of mind
You get a guaranteed, regular income for life, whatever happens to the stock market and even if you sail past your 100th birthday.
Plus, with an annuity, you just make the one decision and then it’s done, so no worrying about investments in the years ahead.
2. The rate can rise with inflation
If you’re willing to start off with a lower income, you could choose an annuity that rises with inflation.
3. A joint annuity will pay your other half an income if you die first
These pay a lower rate to you when you’re alive than a “single-life annuity”, but also provide a spouse or civil partner an income after you pass away.
4. It pays a higher rate if you have a shorter life expectancy
If you have an underlying health condition, you could get an enhanced rate.
Cons to pension annuities
1. You can’t get a refund
There’s no way of changing your mind later and you can’t alter the amount of income you receive each year.
2. Annuity rates are at record lows
Low rates means they can seem bad value.
3. Poor death benefits
If you were to die the day after you take out a single-life annuity, the insurer would swallow all the money.
This means there wouldn’t be anything left of your pension to leave your loved ones.
However, there are some that offer good death benefits as we explain.
Which is better: annuities or drawdown?
It’s always a gamble whether an annuity will be better value than drawdown, because we don’t know exactly when we will die, how the stock market will perform or how inflation will rise.
So in practice, you’ll need to weigh up whether you’d be happier managing unpredictable investments, or relying on a stable income.
The riskier returns from drawdown may make more sense if you have enough reliable income elsewhere to cover your essential bills, such as from the state pension or any final salary pensions.
If you do opt for drawdown, consider keeping a chunky balance in a cash savings account.
You can then use this money to top up your income if stock markets crash, rather than being forced to sell investments at rock-bottom prices.
Find out more: How much should I pay into my pension?
Tax free pension income
Remember that you can take the first 25% of your pension pot tax-free as a lump sum; once you’ve done this you’ll need to weigh up what to do with the remaining 75%.
Bear in mind, you could always combine income drawdown with buying an annuity.
Annuity rates get better as you get older, so you could start off using drawdown, and then use some of your remaining pension money to buy an annuity later.
Pension decisions aren’t easy, so I definitely recommend booking a free appointment with the government’s Pension Wise service for guidance about your options.
If you’re looking at annuities, the Financial Conduct Authority advises you shop around for quotes (this annuity comparison tool from Money Helper is handy). Find out what you’ll get at different ages.
Don’t assume that you have to purchase an annuity from the company that holds your pension pot. You may well find better deals elsewhere.
Consider paying for expert advice from an independent financial adviser – it could be the best money you ever spend.
Whatever you decide, I hope you enjoy spending your retirement savings.
Checklist:
- Book an appointment with Pension Wise
- Get annuity quotes
- Identify any other income in retirement
- Compare potential income from an annuity with drawdown
- Balance the chance for higher returns from drawdown with the reliability of an annuity
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