ANNUITIES V DRAWDOWN – Who wins on points?
If you are approaching retirement and you have a substantial sum accumulated in pension policies then you will be called upon to decide how to draw benefits. You should not automatically buy an annuity without looking at all your options. The bad news is that such options will give many of you a real headache trying to decide which will suit you best. Below we set out a brief précis of the pros and cons of annuities v draw down as an insight into the two main routes open to you.
Conventional Annuities – Suits Cautious Investors
Conventional annuities suit many clients because they offer a guaranteed income for life. You give the insurance company your pension pot and in exchange receive payments based on a level amount or one that increases on an annual basis. The annuity is fixed at the outset and, if it is level throughout lifetime, its buying power will be increasingly affected by inflation.
Buying an increasing annuity can protect the income provided. The
initial payment will be lower than for a level annuity, but by choosing
an escalation option you are buying higher income in future years.
At outset, you must decide if the annuity is to provide for
yourself alone, or yourself and your spouse. The greater degree of
benefits that the contract has, the lower the starting level of income
is.
If you opt to take a tax-free lump sum, which is available
from the pension fund, it must be taken at the outset.
Some pension contracts offer the facility to receive an annuity
at a guaranteed rate decided when the contract was set up. Where offered
these guaranteed rates are often too attractive to miss.
In addition specialist annuities are becoming increasingly
available such as impaired life annuities and annuities for individuals
with a reduced life expectancy.
With profit annuities should also be explored and for larger sums Pension Fund as well as the new form of short-term annuities that run to age 75 when cash sums are returned to the investor for redeployment.
The risks with annuities are:
- Once the annuity has been set up it cannot be changed;
- Once the capital has been paid to secure most forms of
annuities access to the fund is normally lost forever;
- The purchasing power of the annuity income will be eroded
by inflation over a period of time unless escalation is built
in;
- The taxation of the annuity can change.
Pension Fund Withdrawal (PFW) – Suits Equity Based Investors
PFW legislation allows a retirement income to be drawn from a pension pot without having to purchase an immediate annuity. There is the ability to choose a level of income between nil and 120% of the single life annuity. This offers the ability to match income more closely to needs. There is an opportunity to take some or all of the tax-free lump sum at the outset. You can then draw sufficient taxable income whilst allowing the remaining fund to continue to grow in a pension fund environment.
With a Personal Pension Fund (PFW) you can retain control over the
investment by selecting where to invest the funds. Here income
can be withdrawn from selected pension asset funds with the option
to switch into annuities when appropriate. Tax-free cash alone can
be withdrawn leaving income to be drawn down at a later date in the
future.
Under the PFW you can defer annuity purchase until you reach
age 75. You are not tied to one particular annuity rate and
as circumstances change, then a more appropriate annuity can
be purchased at the correct time. No pension
fund might then be wasted buying a widow or widower's pension
benefit, if he or she died before you.
If you die before you purchase a conventional annuity and the
person to whom you have elected to have the benefits paid is your
spouse, he or she will have choices of buying an annuity, or continuing
the draw down, or taking a lump sum less a tax charge. Pension draw
down can thus deliver some IHT mitigation benefit.
Risks of the PFW
Annuity Rate movements cannot be predicted in the future – there has been a considerable fall in annuity rates over the last few years thus reducing the amount of pension that can be purchased if deferred through draw down. Pension assets invested need to grow in value in order to replicate the annuity you could have been bought at the outset. If the assets held within the PFW plan do not grow at a sufficient rate, or worse still lose value, you could ultimately end up with a lower annuity. Taking into account your age and circumstances the required target growth rate should not be onerous - this is known as the critical yield. A critical yield of more than 9% normally does not make draw down viable.
Whichever path is taken each has its advantages and disadvantages. In boxing parlance the victor only wins on points driven mainly by the risk profile of the pension potholder. Often we help people hedge their bets and back both options.
