As the government has been telling us for at least the past 30 years, we should be saving for our retirement. And if you’re the far side of 55, your success in that venture no doubt occupies an increasing portion of your thoughts.
But the truth is – however big your eventual pension pot – you will still have to decide what to do with it. And in the current climate, simply taking the annuity option (however much you shop around) may be extremely bad value.
Low interest rates may be with us for a while longer, but are eventually likely to rise, while inflationary pressures are not going to disappear. In those circumstances, it may make more sense to consider opting for income drawdown.
A new guide from What Investment magazine , exploring the pros and cons of alternative options including income drawdown, with a glossary of terms, could be an invaluable asset. And happily, it’s available as a free download to high50 readers.
Risks of buying an annuity
The trouble is, all too often people just assume they have to annuitise, and never engage with the important alternative options available to them. But once you have bought an annuity (a fixed, guaranteed income for life), you can’t change it. You will never have a second chance at a different option.
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.
1. 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.
2. The second is the risk of dying soon. You can take a ten-year guarantee but, even if you die within the guarantee period, the provider will still keep around half your money.
3. 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.
4. 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.
5. While investing in the stock market might help protect against inflation, if you have bought an annuity, your personal fund will not benefit from such equity returns.
6. And finally, an annuity does not protect you from the possibility that you will need expensive care in later life. Whereas if you are in income drawdown, you may still have some money left for this.
In drawdown, you leave your money invested (in stocks, bonds, funds or whatever) and draw what you need, within certain limits that are set by the government.
You will have the opportunity to benefit from rising markets and thus some inflation protection, while retaining the option of buying an annuity when interest rates return to higher levels.
When income drawdown may not be best
However, there is one major risk against which an annuity may protect you, while drawdown may not: if you live a lot longer than you expected.
Currently, annuities are calculated to assume an average life expectancy of nearly 90, but most people will not live that long. So if you live to 100, an annuity will be better value (though you have to bear in mind that the value of a standard annuity will have dwindled considerably by that time).
Nonetheless, 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, you could 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. (This is explained in the guide.) Leave yourself the option of doing better for yourself later.
Finally, whichever option you choose, don’t forget about fees and charges. (See pages 20-21 in the guide.) Annuities aren’t free: fees are typically 1.5 to four per cent of your fund. Nor, normally, are drawdowns; you will probably incur charges from advisors, administrators and investment managers.
Expensive, you say? Well, they need to save for their retirements, too.