Alternatives to buying an annuity
Annuities have long been seen as the only viable option for most when it comes to retirement income. However new rules mean that, depending on the size of your pension pot, your attitude to risk and how much control you want over your money, there could be alternative options open to you.
Buying an annuity offers a secure and predictable retirement income, so naturally they remain a popular form of retirement income – and we expect this to continue for the foreseeable future.
However, the last few years have seen the rise of the DIY retirement. Because annuity rates had come to be seen as relatively ungenerous, and since annuities are not highly compatible with inheritance planning, the government responded to calls for change with “pension freedom” legislation enacted on 6 April 2015. Since then, people aged 55 and over have been able to decide for themselves how they take money from their pension pot, in a more 'do-it-yourself' approach to financial planning for retirement.
Here are some of the main alternatives to annuities:
Main article: What is drawdown?
New rules on drawdown
Before April 2015, there were two types of drawdown; capped and flexible. Capped gave everybody a permissible amount to take from their pot, while flexible allowed much larger withdrawals provided you had other sources of income. From April 2015, capped and flexible drawdown and their accompanying rules became obsolete, leaving one form of drawdown for everyone.
Drawdown or annuity?
Rather than buying a lump-sum annuity and enjoying its reliable income, opting for drawdown means you keep some or all of your pension pot invested after retirement, so that you can withdraw a regular income directly from your portfolio while the rest remains invested.
Get the investment decisions right, and drawdown can be an opportunity to increase your pension fund value while still drawing a regular income. However, choosing drawdown does mean you take on investment risk and could face running out of money.
Read our full guide to drawdown
Financial advice for drawdown
A financial adviser can provide invaluable help with establishing and managing a drawdown strategy. There will usually be an initial fee for set-up and advice, and then an ongoing fee for reviewing and rebalancing your remaining funds against current and available investments.
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Alternatively you may choose to manage the investments yourself in a SIPP via an investment platform.
Types of drawdown strategy
If drawdown is appropriate, then you need to decide how to generate the income. Do you want to generate a ‘natural income yield’, take withdrawals from the underlying capital, or a combination of the two? The method you choose will determine the types of investments and funds that are suitable for your pension savings.
This is where you only take the income that your investments generate. This provides the opportunity for the your capital to continue to grow and increase the income yield over time. The income can be generated from investing in shares that pay a regular dividend and interest from corporate bonds.
One way of pursuing this strategy is to invest in funds, giving the responsibility of picking the investments to a professional fund manager. A type of fund popular with retired investors is the multi-asset fund, where the fund manager invests in a mixture of shares, bonds and other income-producing assets, with the aim of providing a target income yield.
Withdrawals from capital
If you cannot support the level of income that you require from the natural yield then you may need to draw income from the capital – in other words, by selling investments as you go.
You need to be aware that if you sell investments when the market price has fallen, this can increase the negative impact of the losses and lead to the erosion of your capital sooner that you initially anticipated. To recover losses you may need to adjust the level of income you continue to draw, therefore it is important that you assess both the appetite and capacity that you have to continue to take investment risk during retirement.
Trivial commutation means that you can consolidate smaller pension pots and use them in a way that suits your circumstances.
If you have a smaller pension pot that wouldn't be enough to turn into an income, either with an annuity or through income drawdown, trivial commutation is an option that may be open to you. It's a complicated name for a fairly simple concept. Here's how it works:
- If you're aged between 60 and 74 and your total pension savings are worth less than £30,000, you can take the whole amount as a lump sum to use however you wish
- If you have more than one pension pot and the value of any one is £10,000 or less, you can take this as cash
- The government recently increased the number of pots you can take in this way from two to three, even if the total value of all your pension pots is more than £30,000
Remember that when you withdraw money from your pension pot you can take up to 25% as a tax-free lump sum, but the rest will be subject to income tax.
Instead of converting your whole pension pot into an annuity, opting for drawdown or trivial commutation, you can use a combination of strategies to generate an income in retirement. This goes hand in hand with a phased retirement approach.
You will be able to take up to 25% as tax-free cash at each phase of your retirement plan, with the rest of the income from that phase being subject to income tax. One of the advantages of this approach is that it allows you the flexibility to shape your retirement income around your needs at a specific time. For example, if you develop a health condition later in life you may be able to purchase an enhanced annuity.
If you opt for phased retirement, you'll need to plan ahead to make sure you'll have enough income to cover, at a minimum, your essential expenses throughout retirement. Not all pension saving schemes will include this option, so you'll need to check with your pension provider.
If you don't want an annuity but aren't especially comfortable with the investment options, there are some alternatives if you like to think outside the box. Other retirement income approaches could include:
Bricks and mortar, especially UK residential property bought to let, can yield income that is competitive with annuities. That does not apply to every property and postcode, of course. It also means taking responsibility for managing lettings and maintaining the property; you can undertake this yourself or by paying a managing agent, which will erode some of your margin. Read more on buying-to-let.
If you're taking out another mortgage, this will have Capital Gains Tax implications at best, and risks like negative equity at worst. You'll have to be prepared to cover mortgage payments yourself during any vacant periods.
If you like to 'staycation', buying an investment property in an area you are fond of visiting can provide the best of both worlds, with a managing agent generating bookings but also allowing you, as owners, to reserve times for your own use.
Online peer-to-peer (P2P) lending allows you to lend your cash directly to individuals or businesses that want to borrow, in order to earn a rate of return. Your loan is split between a large number of borrowers, which diversifies the risk of default. There are several peer-to-peer platforms in the UK: Zopa, Ratesetter and Funding Circle are three of the bigger names.
Keep an eye out for limited-issue Guaranteed Growth Bonds, sold by government-backed NS&I and available only to over-65s, which sell out quickly when they're available. In early 2015, these bonds paid a couple of percentage points better interest than open-market cash deposits — 4 percent on a three-year bond and 2.8 percent on a one-year term – so naturally the limited issue of £10bn quickly sold out.
State pension top-up
From October 2015, it will be possible to top up your State Pension by swapping a lump sum for an additional state-backed income for life. This will be inflation-proofed and pay a 50 per cent spouse's benefit when you die. The scheme is not open yet; we will add more details as they become available.
Making the right choice for retirement income
The decisions you make about your retirement income are as crucial as they are complicated – you could be relying on this income for 30 years or more.
If you're not sure of the right strategy or option for you, it's always wise to speak to a financial adviser.
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Last updated: 29 May 2015