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Annuities vs Pension Drawdown: Size Does Matter

Annuities – surely they’re old hat, right?

Since the introduction of the pension freedoms in April 2015, which opened a whole host of flexible ways to access your pension, annuities have seemed less attractive for many. Even before this, rock-bottom interest rates and low yields on government gilts had depressed the annuity rates providers were willing to offer.

When pension drawdown was flung open to the wider market – which sees you take flexible income and lump sum payments from your pension pot – it seemed like another nail in the coffin for annuities.

How much is your pension worth?

However, given the average UK pension pot is worth £50,000 according to research from Aegon, could an annuity be a better option for a pot of this size?

Thanks to a new tool from Drewberry – an Annuity Rates Calculator – it’s possible to compare the outcome for an annuity and pension drawdown side by side.

A £50,000 pension buys a 65-year-old non-smoker from Brighton a guaranteed income of £2,637.72 per year for the rest of their life. If you plug this figure into another Drewberry tool, a Pension Drawdown Calculator, this would see your income run out at 88 assuming 2% inflation and consistent 4% growth.

This is dangerously close to the life expectancy of a 65-year-old man (86) and less than the life expectancy of a woman of the same age (89).

With life expectancy rising all the time – just ask Buckingham Palace, where they’re inundated with requests to congratulate centenarians – this is a big gamble for a small pension pot. Women are especially at risk. Longer life expectancies mean they’re even more likely to outlive their retirement savings, potentially making an annuity all the more suitable for female retirees.

Also, this assumes consistent 4% growth each year. Advisers such as Drewberry will typically undertake cash flow models to replicate real market conditions, which can include the impact of market shocks.

What about inflation?

If you opt to index-link your annuity so it keeps pace with inflation, the amount you’ll receive initially falls. Here the sums are murkier when it comes to whether an annuity is better than drawdown or vice versa – replicating a lower index-linked annuity with drawdown obviously stretches your pot out for longer.

Is freedom worth the risk?

Still, for people with small pots, it might be better to pick the guarantee offered by an annuity rather than risk running out of income in their old age.

Although income drawdown and the pension freedoms offer more in the way of flexibility, letting you decide how and when you take your retirement income, you’ve got to weigh up the pros and cons of your retirement options before deciding.

Ultimately, deciding between income drawdown and an annuity is a conversation between you and your adviser. However, when you’ve got a smaller pension pot, income drawdown may not always be worth the risk.

Written by: Head of Pension Planning, Neil Adams

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