Annuity versus Pension Freedoms: How will you choose?

Category: News

Traditionally, annuities were the way that retirees generated pension income. You would build up a pension pot and then use that to “buy” an annuity – essentially a pension income guaranteed for the rest of your life.

Since Pension Freedoms legislation was introduced in 2015, you now have a wider range of choices.

You can now flexibly access your pension savings, meaning you can draw down variable amounts as your needs change.

Annuities, though, can still play an important part in your financial plan. And, since the start of 2022, annuity rates have increased significantly. Indeed, the Telegraph reports that potential income from an annuity has risen by more than 20% this year alone.

If you’re planning your retirement, you may be asking yourself: should I opt for an annuity or a more flexible choice?

Read on to discover the benefits and disadvantages of both.

Annuities provide you with a guaranteed, regular income that can give you peace of mind

Stable income makes budgeting easier

One of the main benefits of an annuity is the regular and stable income it provides.

No matter how long you live, or how the wider stock market is performing, your annuity will continue to pay out the promised amount.

This makes retirement budgeting very simple. Not only will you know exactly how much pension income you will receive, but you also know when you will receive it.

You can inflation-proof your income  

If you’re thinking of purchasing an annuity, you might want to consider the effects of inflation.

Using an annuity to cover regular, fixed expenses is a great idea but inflation can lower the buying power of your income over time. Choosing an escalating annuity means that the amount you receive rises each year, helping to combat rising inflation.

You might opt for a certain percentage increase or yearly rises aligned to the Retail Prices Index.

Just be aware that a rising annuity is more expensive so the starting amount you receive will be lower than if you take a level annuity.

Annuity rates are at an 8-year high

Potential income from annuities is at an eight-year high, meaning now could be the perfect time to purchase one.

The Telegraph states that the average annual annuity for a 65-year-old with a £100,000 pension pot at the beginning of 2022 was £4,626. This rate now sits at £5,940 a year.

An annuity has the drawback of inflexibility so choose wisely

An annuity can provide peace of mind during retirement and make for simple budgeting. But they are inflexible.

Once you purchase an annuity, you generally can’t change your mind. If your circumstances change, an annuity might no longer be suitable.

Once you accept an annuity quotation you are locked in. If annuity rates rise in the future, you won’t be able to take advantage of this rise.

Finally, it’s worth remembering that you could get back less from your annuity than it costs. If you die soon after purchasing an annuity, the income you get back could be considerably less than the cost of the purchase.

Opting for a guarantee period or a spouse’s pension could help to ensure your loved ones continue to benefit, even after your death.

Pension Freedoms give you great flexibility over your pension savings

One of the other popular ways to receive a pension income is through flexible options, such as “drawdown”.

Using drawdown, you can take 25% of your pension fund as a tax-free lump sum, and then leave the rest invested.

Whatever you don’t take has the potential for future investment growth. You can then decide whether you want a regular income or payments as and when you need them.

Leaving some of your pot invested could also help to mitigate rising inflation, but with the associated risk that your value could fall as well as rise.

There are potential tax benefits on death too. Unused pension funds can be passed to your chosen beneficiaries tax-free on death, in some circumstances.

Flexi-access drawdown has some potential disadvantages too

Flexibility means more budgeting responsibility

Having greater control over your money means you will typically have to budget more carefully.

For example, you could run out of money in later life if you withdraw too much in the early years of your retirement.

You’ll need to think carefully about tax

Once you have taken your 25% tax-free cash entitlement, the rest of the income you drawdown will be subject to Income Tax.

If you were to draw a significant lump sum in one go, you could push yourself into a higher tax bracket.

Also, once you start drawing from your pension using certain flexible options, the amount you can tax-efficiently contribute to your remaining pension fund is restricted. Rather than the £40,000 Annual Allowance (for the 2022/23 tax year), you’ll trigger the Money Purchase Annual Allowance (MPAA) reducing your allowance to just £4,000.

You’ll need to consider this if you plan to keep working but draw some pension income to supplement your earnings.

Get in touch

As you can see, both annuities and drawdown come with benefits and disadvantages.

If you would like to discuss the two further and discover which would best suit you, please email or call 020 8941 9779 to see how we can help you.

Please note

A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future results.

The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates and tax legislation may change in subsequent Finance Acts.