With the introduction of pension freedoms from 2015, those approaching retirement have a much wider range of options available to generate pension income. Although flexible pension options such as Flexi-Access Drawdown remain popular, pension annuities are an alternative that should be considered.
A lifetime pension annuity is a financial product that provides a guaranteed income for life in exchange for a lump sum from your pension pot. As the purchase of an annuity forms a contract with the insurance provider, a lifetime pension annuity will continue to pay the contractual level of income, irrespective of how long you live. The contract is, however, binding on both the insurer and the pension holder, as once a lifetime annuity has been purchased, the decision is usually irreversible.
Weighing up the factors
It is important to carefully consider the positives and drawbacks of an annuity, compared to other options to generate an income from accumulated pension funds, before deciding on any course of action.
Perhaps the biggest advantage of a pension annuity is that the guaranteed income provides certainty. Once in place, the income payments will continue for as long as you live and avoids the potential that you outlive your pension savings if drawing an income via another method, such as drawdown.
An annuity can be arranged on a single life basis, guaranteeing payments for the rest of the pension holder’s life, or set up so that benefits continue to be paid to a spouse or partner in case of death of the annuity purchaser. A further choice is to select a guarantee period, whereby payments will continue for a pre-determined length of time, irrespective of whether the annuity purchaser survives the length of the guarantee period. Each of these options will, however, reduce the amount of income paid.
A pension annuity also avoids the need to consider stock market risk, as the pension savings will have been converted into a guaranteed income. Irrespective of market or economic conditions, the contractual payments will continue. Additionally, as the pension fund has been exchanged for an annuity, no further fund or management charges will be levied.
Whilst pension annuity rates are largely determined by age and life expectancy, enhanced annuity rates may be offered to those with adverse lifestyle factors, such as smokers, or individuals with certain underlying health conditions. Based on underwriting decisions through each insurer, those qualifying for an enhanced annuity may see modest uplifts to the annuity rate offered, as their actuarial life expectancy is shorter.
Drawbacks of lifetime annuities
Whilst the above may make annuities sound appealing, there are drawbacks to consider when guaranteeing an income in retirement through a pension annuity. One of the most serious drawbacks is that once you purchase a pension annuity, the decision is usually final. If your circumstances change in the future, you can’t adjust the pension in payment or resurrect the pension pot. This lack of flexibility can be a major disadvantage as income needs often change through retirement. For example, you may look to spend more in the early years after retirement on lifestyle choices, such as travel, or home improvements. A fixed lifetime annuity does not provide that flexibility, while through drawdown, you can adjust your income to match your spending needs or take a single income payment should an unexpected need arise.
Other than any guarantees that are purchased with a lifetime annuity, the annuity payments will cease on death. In contrast, under flexible retirement income options, such as Flexi-Access Drawdown, any remaining funds can be passed to beneficiaries on the death of the pension holder. This allows the beneficiary to draw a flexible income and effectively allow the value of the pension to cascade down generations. Currently, remaining pension values on death are outside the scope of Inheritance Tax (IHT), further enhancing the attractiveness of the flexible pension options. Despite the change of rules from April 2027, when pension values will form part of an individual’s estate for IHT purposes, the ability to leave residual pension funds to loved ones on death via flexible income methods continues to be attractive and cannot be matched via a lifetime annuity.
Lifetime annuities tend to be arranged on a level basis, which means that the payment stays the same over the life of the annuity holder. Over time, inflation will erode the real value of the annuity income and reduce the purchasing power of the income received. To mitigate inflation risk, you have the option of buying an inflation linked annuity, or an annuity that increases at a set percentage rate each year. This may appear a sensible option; however, the index linked annuity payments start at a much lower income than a level annuity, and it may take many years for the increasing income to match the starting value of a level annuity.
Seek tailored advice
Deciding the best method of generating an income in retirement from pension savings, depends on a range of factors, and the individual’s overall financial position. Annuities can provide certainty and peace of mind; however, the lack of flexibility and inability to pass down residual pension funds to loved ones can help drawdown options look more appealing.
Given that decisions taken at retirement can have lifelong consequences, it is vital that independent and unbiased advice is obtained before reaching a conclusion. Our experienced advisers will take a holistic overview of your financial circumstances and give tailored advice on both flexible and guaranteed pension income options. Speak to one of the team to discuss your retirement income needs.
