What to do with your pension pot as you approach retirement is an important issue to explore.
Most people don’t realise they don’t have to buy an annuity: All too often, people just assume they have to annuitise, and never engage with the important alternative options available to them.
Annuities are irreversible: Once you have bought an annuity, you can’t change it. You will never have a second chance.
Annuities won’t protect you against serious retirement risks: It’s like putting all your eggs in one basket, and it leaves you with no protection against several serious risks that you are likely to face during retirement.
Inflation: Number one is the risk of inflation. Most people buy annuities that offer no protection against rising prices. Even if inflation remains relatively low at around 2.5 per cent a year, you will still lose a big proportion of your real income over 20 years.
Dying young: Second is the risk of dying soon. You can take a ten-year guarantee, but if you die within the guarantee period the provider will still keep around half your money.
Becoming ill: An annuity gives you no defence against failing health. Illness will get you an enhanced annuity rate, but if you buy the annuity and then become seriously ill, you can’t change it.
Changing circumstances or market conditions: Many people will be better off waiting a few years, to see if their circumstances or market conditions change, rather than annuitising all at once.
Interest rates currently artificially low: Buying an annuity today offers no protection against the likelihood of interest rate rises in the future. You are locking into rates that have been artificially held at historic lows by government policy.
Can’t benefit from stock market gains: Investing in the stock market might also help protect against inflation, but if you have bought an annuity your fund will not benefit from equity returns.
Drawdown can help with inflation protection and market rises: Using income drawdown, you will have the opportunity to benefit from rising markets, some inflation protection and retain the option of buying an annuity when interest rates return to higher levels.
Funding long-term care: The final risk that an annuity does not protect you from is the possibility that you will need expensive care in later life. If you are in drawdown, you may still have some money left for this.
Annuities just ensure you receive income each year – but the income will be eroded by inflation over the years: The one major risk that an annuity does help you with, and drawdown may not, is the risk of living a lot longer than you expected. Currently annuities are calculated to assume an average life expectancy of nearly 90. Most people will not live that long. If you live to 100, an annuity will be better value: but you have to bear in mind that the real value of a standard annuity will have dwindled considerably by that time.
Consider other options before committing at current rates: Think very carefully before you commit your entire pension fund to one product at one point in time with no opportunity to change it. If you can afford to wait, take the tax-free cash and then consider whether you might want to wait for the market to improve. And if you have to annuitise, consider just annuitising some, or phasing. Leave yourself the option of doing better for yourself later.
Fees and charges: Finally, don’t forget about fees and charges. Annuities aren’t free: fees are typically 1.5 to 4 per cent of your fund. But be careful of all the fees and charges on drawdown – for transfer, dealing and advice.
I wish you the best of luck with planning your retirement finances.
This blog is taken from the Foreword I have written in the WhatInvestment Guide to Income Drawdown, which you can link to from here: http://www.whatinvestment.co.uk/investment-decisions/sipps-and-retirement/2401507/the-what-investment-guide-to-income-drawdown.thtml