In the past, the standard approach to using a pension pot was to take an entitlement to a tax-free cash lump sum (typically 25% of the value of the pension pot) and then buy an annuity with the balance of the fund.
An annuity (sorry that word sounds like a piece of jargon) is simply a means for converting capital into a lifetime stream of guaranteed income.
For a lot of people entering retirement, having a guaranteed income sounds like an important thing to have. However, annuity rates today are much, much lower than they have been. historically. Therefore, the amount of guaranteed retirement income provided for each £1,000 of a pension fund is much lower than say a decade ago.
A lot of pension plan owners have been put off buying an annuity because they perceive the amount they will receive as poor value for money. Another reason people are put off annuities is that they tend to underestimate their own life expectancy. Combine these perceptions, and you can see why the number of annuities purchased has fallen.
The alternative approach of flexible access drawdown has taken off since the then Chancellor announced its introduction back in 2015. With flexible access drawdown, after the tax-free cash lump sum has been taken, the pension plan owner decides how much “income” to take and when.
Please do note that “income” might be a combination of income produced by the investment funds (dividends, interest and rent for example) and some of the pension fund capital.
So, rather than handing over the pension fund capital to an annuity provider, the pot remains invested.
With an annuity, there are advantages and disadvantages such as;
- the income is payable for as long as you live;
- in the event of your death the income might continue to be paid to a surviving spouse or partner;
- the older you are when you buy the annuity, the more likely the income will start at a higher level; and
- if you have a history of poor health you might be entitled to an enhanced income payment.
- once you have died (and a surviving spouse or partner has died) no further payments will be made;
- if you choose an annuity that doesn’t increase in payment its value will gradually be eroded by inflation; and
- once you have bought an annuity that contract cannot be unwound or changed.
It might still make sense to use some of your pension pot to buy an annuity to cover all your essential spending in retirement (utilities, food, clothes etc.) and then use the balance of your pension pot to take flexible benefits.
As always, we suggest you receive suitable financial planning and advice before deciding what to do with your pension pot.