After decades of building up your pension pot, that last thing you want is to run out of money in retirement. Yet recent pension freedoms have muddied the waters over what you should do with your savings; do you buy an annuity or opt for more flexibility?
Before pension freedoms, the retirement income options available to you were limited to buying an annuity – where you swap your pension for a reliable income until you die, guaranteeing financial security throughout retirement.
The income you get from your annuity is expressed as a percentage of the amount you transfer – so if you agree a 5% rate on a £200,000 pension pot, you’ll get £10,000 a year.
Before you get a quote, your annuity provider will take many things into consideration, including your age, gender and lifestyle. If you have a serious health condition, you’re likely to get a higher rate than someone who’s expected to live for longer.
You can also opt for a variable annuity rate over a fixed one, although these are complex products that remove the attractive feature of annuities: regular cash flow.
Pros and cons of an annuity
Your annuity provider invests your lump sum in government bonds, so the rate you’re offered depends on the bank rate set by the Bank of England, which is currently sat at 0.25%.
This has had a knock-on effect on the returns offered by annuity providers, which have slumped over the last three decades.
You only get one chance to buy an annuity, so it’s crucial you understand what you’re buying and are making the most of what you have. If you have an emergency that you haven’t budgeted for you won’t be able to access your money.
Once you buy an annuity, you’re locked in for life, and unless you select either a joint-life annuity or value-protected annuity, you won’t be able to pass on your pension savings when you die.
The security of regular income is reassuring in a time when people are living longer, but saving less. Whilst you might struggle to find a decent rate of income in an era of low interest rates, an annuity can be a reliable part of financial planning for retirement.
How have pension freedoms changed things?
Designed to overhaul the pensions landscape and unlock new opportunities for savers looking forward to retirement, pension freedoms have really made a complicated environment more confusing.
Before pension freedoms, you could still take 25% of your savings tax-free from the age of 55, although you had to buy an annuity with the remainder of your money.
Today, you have more choice over what you do with your savings and you’re no longer required to buy a guaranteed income stream in the form of an annuity.
Other options include a flexible income drawdown product, or you can take it all in cash – a quarter will be tax free and you’ll pay your normal rate of income tax on the rest.
It’s now normal for savers to access their pension early, with most choosing to withdraw lump-sums instead of regular income, recent research from regulator the FCA shows.
Over half of the pensions accessed early have been fully withdrawn, although nearly all of these savers have had other forms of reliable retirement income aside from their state pension.
Highlighting the demand for more flexible ways to access your savings in retirement, more people are choosing an income drawdown product, with twice as many pots moving into this type of pension over annuities.
What is income drawdown
Income drawdown gives you a more flexible approach to your income during retirement. By keeping your savings invested in the market, you can dip into your money as you like. You can still take your 25% tax free lump sum from the age of 55, paying usual rates of income tax on the remainder.
By keeping your pension invested, you’re hoping your money will continue to grow in value to help offset the impact of inflation – although it can fall in value too. There are different charges and you should always shop around to make sure you get the best deal for you and your family.
Brits deserve flexibility and choice when it comes to their pension, but it’s important that savers fully understand the risks of pension drawdown.
You will need to work out how much you need to afford the retirement lifestyle you’ve been dreaming of. You’ll need around £26,000 a year to live a comfortable life with a couple of holidays in Europe a year, research from consumer group Which? shows.
It’s up to you how much you withdraw, but the 4% rule is seen as a good benchmark for a 30-year retirement period.
You need to make sure you don’t splurge all your cash on holidays, fast cars and home renovations in the first couple of years.
Once you’ve spent your money, that’s it – you’re not guaranteed an income and will have to rely on the state pension. Unless you reached state pension age before 6 April 2016, you’ll get £164.35 a week from the state pension – the previous basic pension is set at £125.95 a week. The new state pension increases each year by either UK wage growth, inflation, or 2.5%, whichever is higher. This is known as the state pension triple lock.
Income drawdown does allow you to have more control over how you plan to live your retirement, and gives you the option to dip into your funds in an emergency. But it’s important you remember that your pension needs to last as long as you do – retirement can last over three decades depending on how long you live.