Agonizing over whether to annuitise or use drawdown for retirement can feel like being stuck at a cross roads. But it doesn't have to, because you can have both.
If you want guaranteed income for the rest of your life but you don't want to miss out on the opportunity for higher returns though investing, a dual approach to annuities and drawdown could solve your dilemma. But investors with modest pensions should proceed with caution.
Why not just settle for an annuity?
Annuity rates are on the floor. You'd be doing well to get £5,500 a year income from a £100,000 pension pot at age 65 with current level annuity rates. Inflation is also a beast that threatens to flatten the value of level annuities over the medium to long term. While you can buy an annuity that rises with inflation, the rates are much lower. The combination of these puny rates and the risk posed by inflation are shifting shrewd eyes elsewhere, to a more lucrative, but risky retirement income alternative: drawdown.
Why not just settle for drawdown?
Under 'capped drawdown' you can keep your pension invested, while being allowed to draw an annual income of the maximum 120 per cent GAD rate. This is related to 15-year gilt yields and allows a man aged 65 to draw 6.7 per cent of his pot as income. However, you are at risk of running out of money before you die or depleting your pot so your income isn't enough to keep you comfortable in your later years.
Unlike annuities, which are guaranteed to last, drawdown gives you the power to put your foot on the pedal too hard and guzzle your fund too fast. Plus, if your investments perform badly your capital will be reduced, with a knock-on effect on your income.
Funnelling a portion of your pot into an annuity while putting the rest in drawdown means you're getting the 'safe place' benefits of the annuity while also getting the potential for some more exciting returns from your drawdown investments.
So is a dual retirement income solution something you should consider? Here are a few different investor scenarios to help you decide.
1. You have a pension pot of less than £200,000 and no other assets
Be wary of drawdown if you have a modest pension pot and no other assets to fall back on in retirement. You will need to do a thorough breakdown of the costs involved with opting for a dual retirement income as you're at risk of cost inefficiency.
2. You have less than £20,000 guaranteed pension income, plus less than £100,000 in a pension pot
Financial advisers don't recommend going into drawdown with anything less than £100,000 because proportionately to the pot, the costs become so big they gobble up too much of the pot to make it worth doing.
If you're a DIY investor you'll have to shell out for drawdown set-up fees and the ongoing charges associated with the investments in it (see table). And if you go through a financial adviser you'll have to shell out for advice as well as a set of ongoing charges for the management and reviewing of the investments, making it even less cost efficient.
If drawdown does look expensive, annuitising your whole pot might be a cost-efficient move. But not all annuities are good value for money, either - due to the hidden costs and commissions that come with them (see table). So make sure you shop around for the best rates and apply for an enhanced annuity if you have a medical condition or you're a smoker or heavy drinker, as you could get an uplift as big as 60 per cent on your income.
Conclusion: A dual approach might not be cost-effective for you. Despite low rates and hidden charges, annuitising your whole pot might be better value for money than using drawdown for part of your pot because of the charges you will have to fork out for drawdown.
3. You have less than £20,000 or more pension income and more than £100,000 in a pension pot
If you have more than £100,000 you'd like to put into drawdown (after buying a decent-sized annuity to give you some security, or if you've got a defined benefit pension that covers your basic needs) you could consider a 'bit of both' retirement income solution with the rest of your pot.
You really need more than £100,000 to make drawdown cost efficient because the smaller your pot, the bigger the associated set-up costs and ongoing charges are.
Remember you can always turn your back on drawdown at any point and take your pot to be annuitised if you find you want more security later down the line. This could be a smart move if you think you might qualify for an enhanced annuity (with rates up to 60 per cent higher than standard annuities, designed for people with shorter life expectancies due to medical conditions) in a few years, as you could enjoy greater flexibility now and then cash it in when you can get a better rate.
Conclusion: A dual approach can be a cost-effective route to higher income. If you already have secure pension income and you're after some flexibility with the rest of your pot, capped drawdown can be achieved cost-effectively and will allow you the potential to beat lousy annuity rates. Reconsider annuitising the pot when you reach 75 or if your health deteriorates.
You have £20,000 or more pension income and more than £100,000 in a pension pot
If you have £20,000 or more of existing guaranteed pension income (including the State Pension) you are allowed to spend or invest the rest of your pension money exactly how you like.
This option is called flexible drawdown - an alternative for wealthier investors who want to avoid the restrictions capped drawdown places on the amount of income you can take from your pension pot.
If you have a defined benefit pension that will pay you £20,000 or more a year, you'll already qualify for flexible drawdown, but if you don't, you can use some of your pot to buy an annuity to buy this level of income, so you can do what you like with the rest.
This could be a good option if you have a big pot of money and the confidence that you won't bleed your pot dry (remember if you're turning 65 your life expectancy could be another 25-35 years).
When you die, your annuity won't be passed on to your family, which could be galling if you've got a big pot and you die just a few years after buying the annuity. But flexible drawdown, on the other hand, allows you to give the income from you draw down to your family, tax-free (although they will be taxed at their normal income tax rate) until you reach 75, after which you will be taxed at 55 per cent. So it is a smart move for anyone aiming to leave something behind for inheritors.
The way drawdown costs are applied means bigger pots get better value for money and this is also worth noting if you're concerned about frittering money away on fees.
Conclusion: A dual approach is a cost-effective route to combine safety and maximum flexibility of income. If you already have secure pension income (whether it's from an annuity or not) and you're after some flexibility with the rest of your pot, flexible drawdown will give you the freedom you want - as well as the flexibility to manage tax efficiency if you have other maturing assets. Reconsider annuitising the pot when you reach 75 or if your health deteriorates.
How much will annuities and drawdown cost you?
| Pot below £75,000 | Pot above £75,000 | Pot above £250,000 | |
| Service | No advice annuity | Focused advice on annuities and drawdown | Retirement planning advice |
| Cost for annuity/drawdown | Commission, 1.5 per cent on a standard annuity, 2.5 per cent for an enhanced annuity. | Fee-based advice typically between 1.5 and 2.5 per cent depending on complexity | Fee-based advice - around £150 to £250 per hour |
| Drawdown advice | Fee-based advice, typically between 2 and 3 per cent | Fee-based advice - between £200 and £300 an hour | |
| No-advice annuities | Rebate of annuity commissions between 25 per cent and 75 per cent depending on fund size | ||
| No-advice drawdown | Set-up costs and investment charges - typically £300 set up and 1 per cent annual management charge | ||
| Billy Burrows, director at Better Retirement, says: | "Non advised annuities are becoming much more popular." | "There is more need for advice here as annuity rates are so low and these people need more flexibility." | "Advice is often needed here because of the complexity and the range of options." |
Source: Better Retirement
Weigh up the tax and death benefits of annuities and drawdown
| Annuity | Drawdown | |
| Tax implications | You will be taxed at your normal income tax rate according to your income level. If you have a joint life annuity, once your spouse starts receiving your income they will be taxed according to their income, which may differ from yours. Capital gains tax and inheritance tax do not apply. | You will be taxed at your normal income tax rate according to your income level. Because your income is flexible you can choose to take no income in a year in which you have another asset maturing, if you want to avoid paying too much tax. Capital gains tax does not apply. |
| Death benefits | You can only pass your annuity on to your spouse if you have a joint annuity or an investment linked annuity with limited value protection. | You can pass your pot on to a dependant and they can draw income from it, paying income tax at their normal rate. Or they can choose to have it as a lump sum, but if they do it will be taxed at 55 per cent. If you die aged 75 or over, your pension will be taxed at 55 per cent if the pot is passed on as a lump sum to your family. |
