With the introduction of the Pension freedoms, the key decision for many nearing retirement is between an Annuity or pension drawdown.

There are three main types of annuity but all deliver a guaranteed income for life in exchange for a pension fund. When entering into an annuity contract the yearly income offered varies with the provider, the type of annuity and the economic conditions at the time.

Flexi-access drawdown became an option post the pension freedoms 2015. One, or more, existing pension funds may be transferred (drawn down) into an alternative pension fund. This fund is then managed appropriately to give a (flexible) income. It is up to the individual to manage those investments appropriately to ensure they last their lifetime.

The decision between annuity or pension drawdown should be taken as part of your overall retirement income investment strategy.The advantage of an annuity is your longevity risk is minimised but, when compared to pension drawdown, this comes at a cost. Although drawdown does offer several potential advantages over an annuity these advantages must be measured against the key advantage of an annuity – the lifetime guarantee.

Annuity

With an annuity, your retirement income is guaranteed for life. If you die soon after retirement you generally lose out but if you live into your late 80’s and beyond then an annuity is a more attractive option. However, annuity values have remained relatively low over recent years with alternative options potentially offering potentially significantly better returns.

Annuity rates (how much is offered per annum) are priced in relation to yields on gilts. When their rate of return falls annuity rates fall. This situation only affects those considering purchasing an annuity, those already with an annuity are unaffected and their rates are fixed.

Gilts are perceived as a safe haven for investors in times of economic uncertainty. The return (yield) tends to be low but there is a very low risk the investment will not be re-paid. With the uncertainty generated by Brexit, more investors purchased Gilts. This, in turn, drove down the returns (yield) available from those Gilts.

Historic information shows a 1% drop in Gilt returns causes a 10% drop in Annuity rates. Immediately post Brexit Gilt yields dropped from 1.36% to below 1%. In response annuity rates from all the top providers fell between 2 and 3%.

Annuity rates vary according to post code, the type of annuity and several other factors. The historic low point for annuity rates was August 2016. At that point assume (as a rough guide) an available pension pot of £1m and annuity purchase at age 65. At the low point, this would generate a yearly income of approximately £25,000p.a for life. £25,000 is below the average UK salary and as most individuals are somewhat short of a £1m pension fund at retirement.

Drawdown

Drawdown delivers the opportunity to make your own investment decisions to achieve higher returns. It offers the opportunity to pass on whatever remains in your pension fund to children when you die.

It is important to remember investment decisions must be appropriate to ensure your retirement income does not run out in retirement leaving you, and/or your partner, at the mercy of any state provision that may exist at the time. Recent research shows that those reaching retirement age in 2030 will on average live to over 85 years of age (Male) and over 87 years (Women).

Pension funds in drawdown should be invested in a wide portfolio of assets including equities (shares), commodities and gilts and bonds, among others. Unlike an Annuity where the monthly payment is fixed the value of investments may rise or fall depending on market conditions. It is therefore essential to build a well balanced investment portfolio and manage that portfolio (or pay someone to do so) over the long term.

A short term fall in investment value is not necessarily a problem unless it is necessary to drawdown a sum in the short term. The main issue to consider is will there be sufficient medium term growth in investment returns to cover the short term losses.

If inflation remains low and (after the initial shock) the economy starts to grow again it should be possible in most cases to recover initial losses but there are no guarantees. For those in drawdown, it is important not to make any short term or panicked decisions but to ride out the situation (if possible) and make more balanced decisions in the medium term.

Should you wish to discuss if annuity or pension drawdown is the best option for you given your individual circumstances then please do not hesitate to call on 0800 043 8341 or Email [email protected].

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