Annuity vs flexi access drawdown - Which is best for me?

Annuity vs flexi access drawdown – Which is best for me?

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    Navigating retirement options can be daunting, but we’re here to help you make informed decisions for a secure financial future. Choosing between Flexi-Access Drawdown and Annuity requires careful consideration of various factors. Both options present unique advantages and challenges that can shape your retirement landscape.

    Annuities offer a guaranteed income for life, providing financial stability but lack flexibility. Flexi-Access Drawdown offers flexibility but requires active management and carries investment risk. The choice depends on individual preferences, goals, and risk tolerance.

    In this blog, we’ll explore the intricacies of Flexi-Access Drawdown and Annuity, highlighting their features, benefits, and potential drawbacks. Whether you’re a seasoned investor seeking to maximise flexibility or a risk-averse individual craving financial stability, our guide aims to equip you with the knowledge needed to make informed decisions about your retirement income strategy.

    Contact Heritage Financial Planning for pension advice based on your personal circumstances.

    What is an annuity?

    An annuity is a financial product that is used in retirement to provide a guaranteed income stream in exchange for a lump sum payment. It offers regular payments over a specified period, often for the rest of the recipient’s life, providing financial stability throughout retirement.

    How does an annuity work?

    An annuity serves as a retirement tool that functions on a simple yet effective premise. Imagine it as a long-term investment where you provide a lump sum of money to an insurance company or another financial institution. In return, you receive a steady stream of income over a fixed period, typically for the rest of your life.

    The mechanics behind annuities are pretty straightforward. Let’s say you’ve saved up a considerable sum in your pension pot to fund your retirement. Instead of keeping it invested in the stock market, where you would be at the mercy of market returns, or keeping it all in cash, where it may not generate much return, you can opt to invest your pot into an annuity. This decision allows you to secure a fixed or variable stream of payments, depending on the type of annuity you choose.

    Here’s how it works: You make an initial lump sum payment, usually using all of your pension pot, to the annuity provider. In return, the provider guarantees to pay you regular income instalments for the duration of the annuity contract. The size of these payments is dependent on the annuity rates available at the time of purchase.

    Annuity rates are influenced by various factors, including the annuitant’s age, gender, health status, prevailing interest rates, and the type of annuity chosen. Higher annuity rates result in higher income payments, while lower rates correspond to lower income payments.

    Additional Annuity Options

    The level of annuity income you receive will also depend on any other “bells and whistles” you decide to add to your annuity. The more “bells and whistles” added, the lower the amount of annuity income that is paid out.

    These add-ons include:

    • Indexation – Indexation adjusts annuity payments for inflation over time. Payments increase periodically based on an index, like the RPI, to maintain purchasing power. Although it results in lower initial payments, indexation provides greater financial security for retirees facing rising living expenses.
    • Guarantee Period – An annuity’s guaranteed period is the duration during which payments are guaranteed to be made. The period usually ranges from 5 to 30 years. If the annuitant dies during this period, the remaining payments go to their beneficiaries.
    • Spousal Benefit – This option ensures that if the owner of the annuity passes away, their spouse or partner will continue to receive income payments for the rest of their life. The benefit amount can be set at 50%, 67%, or 100% of the original income. However, the higher the spousal benefit, the lower the annuity paid to the owner.

    What happens to an annuity when you die?

    A lifetime annuity ensures a steady income throughout your lifetime, typically ceasing upon your death. You may, therefore, wish to consider different provisions you can provide for those you might leave behind.

    As mentioned previously, one such option is a Spousal Benefit for your dependent. This could be an annual income to your spouse or registered civil partner payable after your death. The amount they’ll receive can be set at 50%, 67%, or 100% of your own income.

    You could opt for a Guaranteed Period option when you purchase an annuity to ensure that your income is paid for a minimum period from the date your annuity starts. If you die during your chosen period, the company providing your annuity will continue to pay your beneficiary or estate until the end of your chosen period. The guaranteed period typically lasts between 5 and 30 years, and the cost of the guaranteed minimum payment period will reduce the income you receive.

    Finally, Value Protection is an option you can choose to protect some or all of the amount you used to buy an annuity. It is an alternative to providing an income to your beneficiary or estate after you die. In case of your death, the annuity company may pay a lump sum (minus any income payments already made to you) to your beneficiary or estate for the amount you protected. You can typically choose to protect 25%, 50%, 75%, or 100% of the initial amount used to purchase your annuity.

    Advantages of annuity

    Advantages of an annuity include:

    1. Guaranteed Income: Annuities provide a reliable stream of income for life, offering financial security in retirement.
    2. Regular Income: An annuity can provide a reliable monthly income, similar to the regular income that you received during your working life. This can help you budget and plan for expenses during retirement.
    3. Protection for your Loved Ones: Options such as spousal benefits ensure continued income for surviving spouses or beneficiaries.
    4. Inflation Protection: Some annuities offer indexation, adjusting payments to keep pace with inflation and maintain purchasing power.
    5. Lower Investment Risk: Unlike other retirement vehicles, annuities do not require active investment management, providing peace of mind that your pension will not vary depending on stock market fluctuations.
    6. Longevity Risk Mitigation: Annuities protect against outliving retirement savings by providing income for life regardless of how long you live.

    Disadvantages of annuity

    Disadvantages of an annuity include:

    1. Lack of Flexibility: Once purchased, annuities cannot be reversed, this means potentially limiting access to funds in the future.
    2. Potential Loss of Capital: With some annuities, the initial investment may be lost if the annuitant passes away before receiving payments equal to the amount used to purchase the annuity.
    3. Inflation Risk: Fixed annuities may not keep up with inflation, leading to a decrease in purchasing power over time.
    4. Tax Treatment: Annuity payments are usually fixed and regular, making tax mitigation more difficult and potentially resulting in higher tax liabilities.
    5. Complexity: Before buying an annuity, it’s crucial to fully comprehend the terms and features – these products can be complicated. To ensure you make an informed decision, take the time to understand the details.
    6. Lack of Market Growth: You will not benefit from any potential market growth.
    7. Loss of Estate: Most annuities do not protect the value of the annuity after death, which could lead to the loss of a large inheritance to pass on to your family.

    What is a Flexi-Access drawdown?

    Flexi-Access Drawdown is a retirement income option that allows individuals with a defined contribution pension to withdraw funds flexibly from their pension pot while keeping the remaining pension invested.

    This approach offers greater control over how and when pension savings are accessed, allowing retirees to tailor their income to their needs. Unlike annuities, which provide a guaranteed income for life, Flexi-Access Drawdown does not guarantee a specific level of income and is subject to investment risk. Additionally, income withdrawn from Flexi-Access Drawdown is typically subject to income tax.

    How does a Flexi-Access Drawdown work?

    Flexi-Access Drawdown allows individuals with a defined contribution pension to access their pension savings flexibly.

    Here’s how it works:

    1. Pension Pot: When you reach retirement age, typically 55 or older (increasing to age 57 from 2028), you can access your pension pot.
    2. Withdrawals: With Flexi-Access Drawdown, you have full control over how much income to withdraw from your pension pot and when you want to withdraw it. You can take regular withdrawals, lump sums, or a combination of both.
    3. Pension remains invested: Unlike annuities, where you exchange your pension pot for a guaranteed income, with Flexi-Access Drawdown, your pension pot remains invested. This means it has the potential to continue growing (or shrinking), depending on how the underlying investments perform.
    4. Investment Management: You have control over how your pension pot is invested, giving you the flexibility to adjust your investment strategy based on your goals and risk tolerance.
    5. Income Tax: Withdrawals from Flexi-Access Drawdown are subject to income tax. However, you have the option to take 25% of your pension pot as a tax-free lump sum, with the remaining withdrawals taxed at your marginal income tax rate. However, it should be noted that it may not be beneficial to take the 25% tax-free cash all in one go. You should consult with a financial adviser on the best course of action here.
    6. Death Benefits: If you die before age 75, the remaining funds in your pension pot can be passed on to your beneficiaries tax-free. If you die after age 75, your beneficiaries will pay income tax on withdrawals from the pension pot at their marginal tax rate.

    Overall, Flexi-Access Drawdown offers flexibility and control over your retirement income, allowing you to tailor withdrawals to your individual needs and circumstances. However, it’s important to consider the potential risks, such as investment volatility and the possibility of running out of money in retirement.

    Consulting with a financial adviser can help you make informed decisions about whether Flexi-Access Drawdown is suitable for your retirement planning needs.

    How much will I be taxed from a pension drawdown?

    The amount you’ll be taxed in pension drawdown depends on various factors, including the size of your withdrawals, your total income from all sources, and your personal tax situation.

    Withdrawals from your pension pot are typically subject to income tax at your marginal income tax rate. This means that the amount you withdraw is added to your total income for the tax year, and you’re taxed according to the tax bands applicable to your income level.

    Additionally, you have the option to take 25% of your pension fund tax-free as a lump sum, with the remaining pension pot withdrawals subject to income tax at your marginal rate.

    Due to their unique tax treatment, Uncrystallised Funds Pension Lump Sums (UFPLS) can result in a lower tax liability. When taking a UFPLS, only 25% of each withdrawal is tax-free, with the remaining 75% subject to income tax. However, because each withdrawal is treated as a combination of tax-free and taxable amounts, it allows retirees to manage their tax liability more effectively.

    By spreading withdrawals over multiple tax years or taking smaller UFPLS amounts, retirees may stay within lower tax brackets, potentially reducing their overall tax burden compared to taking a large lump sum or regular income from other pension options.

    To learn more about the different pension options you can take read our blog.

    Additionally, for retirees with no other sources of income, the first £12,570 (as of the tax year 2022/2023 in the UK) is taxed at 0%, making UFPLS withdrawals a potentially tax-efficient way to access pension funds.

    It’s important to consult with a financial adviser or tax professional to understand how income drawdown withdrawals will affect your overall tax liability based on your individual circumstances and tax regulations.

    What happens to a drawdown pension on death?

    In Flexi-Access Drawdown, what happens upon the death of the account holder depends on their age when they pass away:

    1. Before Age 75: If the account holder dies before reaching the age of 75, any remaining funds in their Flexi-Access Drawdown pension pot can typically be passed on to beneficiaries tax-free. Beneficiaries have the option to withdraw the funds as a lump sum or continue with drawdown, receiving regular income payments. The tax treatment is generally favourable, with no income tax payable on the inherited pension pot.
    2. After Age 75: If the account holder dies after reaching the age of 75, any withdrawals made by beneficiaries from the inherited pension pot are subject to income tax at their marginal rate. This means that beneficiaries will pay income tax on withdrawals according to their tax band, similar to how they would be taxed on any other income.

    Pension pots are also not subject to inheritance tax when you die because they do not form part of your taxable estate. Therefore, sometimes refraining from using your pension pot instead of using it straight off the bat to fund your retirement can prove a tax-efficient strategy when planning to leave assets to family members or future generations.

    Advantages of Flexi-Access Drawdown

    The advantages of Flexi Access Drawdown include:

    1. Flexibility: Flexi Access Drawdown offers flexibility in accessing pension funds, allowing retirees to tailor withdrawals to their individual needs.
    2. Control: Retirees retain control over their pension savings and investment decisions, enabling them to adjust their income according to changing circumstances.
    3. Investment Growth Potential: Unlike annuities, which provide a fixed income, Flexi Access Drawdown allows pension funds to remain invested and potentially benefit from market growth.
    4. Tax Efficiency: Withdrawals from Flexi Access Drawdown are typically taxed as income, offering potential tax planning opportunities and allowing retirees to manage their tax liabilities.
    5. Death Benefits: Flexi Access Drawdown provides flexibility in passing on pension funds to beneficiaries, with potential tax advantages depending on the age at death.
    6. No Requirement for Immediate Purchase: Unlike annuities, which require immediate purchase, Flexi Access Drawdown allows retirees to defer decisions and maintain access to their pension savings until needed.
    7. Income Tailoring: Retirees can choose the timing and amount of withdrawals, allowing them to match income to expenses and maximise pension savings.
    8. Inheritance Planning: Flexi Access Drawdown provides inheritance planning options, allowing retirees to pass on pension funds to family members or future generations.

    Overall, Flexi Access Drawdown offers retirees greater control, flexibility, and potential for investment growth compared to traditional annuities, making it a popular choice for pension income in retirement.

    Disadvantages of Flexi-Access Drawdown

    The disadvantages of Flexi Access Drawdown include:

    1. Investment Risk: The main disadvantage of Flexi Access Drawdown, in my professional opinion, is that it exposes your pension funds to investment risk. This means the value of your pension pot can fluctuate based on market performance, potentially leading to a lower retirement income.
    2. No Guaranteed Income: Unlike annuities, which provide a guaranteed income for life, Flexi Access Drawdown does not offer certainty of income, making it challenging to plan for long-term financial needs.
    3. Management Complexity: Managing investments within Flexi Access Drawdown requires financial expertise and ongoing monitoring to ensure the pension pot lasts throughout retirement, which may be daunting for some retirees.
    4. Tax Implications: Withdrawals from Flexi Access Drawdown are subject to income tax, potentially resulting in higher tax liabilities, especially if large withdrawals are made or if other sources of income push retirees into higher tax brackets.
    5. Inflation Risk: Without inflation protection, the purchasing power of pension income may erode over time, especially if investment returns fail to keep pace with rising living costs.
    6. Longevity Risk: Flexi Access Drawdown carries the risk of outliving pension savings, particularly if retirees withdraw funds too rapidly or if investment returns are lower than expected.
    7. Lack of Spousal Benefits: Unlike annuities, which may offer spousal benefits or survivor options, Flexi Access Drawdown does not provide guaranteed income for surviving spouses or beneficiaries after the account holder’s death.
    8. Complexity of Options: The range of investment choices and withdrawal options within Flexi Access Drawdown can be overwhelming, requiring retirees to make complex decisions about asset allocation and income strategy.

    Overall, while Flexi Access Drawdown offers flexibility and control over pension funds, it also comes with risks and complexities that retirees need to carefully consider before opting for this retirement income option.

    What to consider before choosing how you would like to withdraw from your pension pot

    Before deciding how to withdraw from your pension pot, consider the following factors:

    1. Income Needs: Assess your current and future financial needs, including essential expenses, discretionary spending, and any other sources of income or retirement savings.
    2. Lifestyle Goals: Consider your lifestyle preferences and aspirations for retirement, such as travel, hobbies, and other activities that may require additional funds.
    3. Risk Tolerance: Evaluate your comfort level with investment risk and market volatility, as different withdrawal options carry varying degrees of risk to your pension savings.
    4. Tax Implications: Understand how you pay tax on different withdrawal methods, including income tax rates, allowances, and potential tax planning opportunities.
    5. Longevity Planning: Consider your life expectancy and plan for longevity by ensuring your chosen withdrawal strategy can sustain your income needs throughout retirement.
    6. Inflation Protection: Consider options for protecting your income against inflation to ensure that your purchasing power remains stable over time.
    7. Spousal Benefits: If applicable, consider the financial needs of your spouse or partner and explore options for providing them with ongoing income in the event of your death.
    8. Health and Medical Expenses: Assess your health status and potential future medical expenses, as well as any provisions for covering long-term care costs.
    9. Legacy Planning: Determine whether leaving a financial legacy to loved ones or charitable causes is a priority and how different withdrawal options may impact your ability to pass on wealth.
    10. Professional Advice: Seek pension planning advice from an independent financial adviser or retirement specialist who can help you evaluate your options, understand the implications, and make informed decisions aligned with your goals and circumstances.

    How can Heritage Financial Planning help me?

    As independent financial advisers, we can assist you in evaluating the pros and cons of annuity vs. drawdown options, offering personalised guidance tailored to your financial circumstances and retirement goals.

    Take advantage of Heritage Financial Planning’s complimentary Retirement Masterclass. This is a 30-minute financial review with a specialist Chartered Independent Financial Adviser, where you’ll gain insights into comfortable retirement timing, effective spending strategies, and potential acceleration of your retirement timeline, addressing key questions on retirement savings, timeline, and investment optimisation.

    Book your FREE Retirement Consultation today.

    Conclusion

    To answer the perennial question – Annuity vs. Drawdown – here is a useful summary!

    Annuity:

    • Provides a guaranteed income for life in exchange for a lump sum from your pension pot.
    • Offers financial stability and predictability with fixed-income payments.
    • Protects against investment risk and market volatility.
    • May lack flexibility and potential for growth compared to drawdown options.

    Drawdown:

    • Offers flexibility in accessing pension funds, allowing retirees to tailor withdrawals to their needs.
    • Allows pension savings to remain invested, potentially benefiting from investment growth.
    • Provides control over income and investment decisions but carries investment risk.
    • Requires ongoing management and monitoring to ensure pension funds last throughout retirement.

    In summary, an annuity provides a guaranteed income for life but lacks the flexibility of drawdown. A drawdown has the potential for growth but requires active management and carries investment risk. The choice between annuity and drawdown depends on individual preferences, financial goals, and risk tolerance.

    Frequently asked questions about annuities and flexi access drawdowns

    Can I draw down 100% of my pension?

    Yes, it’s possible to draw down 100% of your pension pot. Flexi-Access Drawdown allows retirees to access their entire pension pot as a lump sum; typically, 75% of this will be subject to income tax.

    How many times can I drawdown from my pension?

    In general, there is no limit to the number of times you can draw down from your pension pot. Flexi-Access Drawdown allows retirees to make withdrawals as needed, whether as lump sums or regular income payments, subject to the rules and restrictions of the pension provider.

    Does pension drawdown count as income?

    Yes, pension drawdown counts as income for taxation purposes. When you withdraw money from your pension pot through drawdown, it is treated as taxable income and is subject to income tax at your marginal tax rate. The amount of tax you pay on pension drawdown depends on your total income for the tax year, including other sources of income such as salary, dividends, and rental income.

    Alex Norman-Jones​

    Alex Norman-Jones​

    I am one of the founders of Heritage and I am highly motivated to deliver bespoke financial planning solutions to my clients.

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