An annuity provides simplicity and provides you with a guaranteed income for lifetime or a fixed term period. Whereas drawdown (FAD) provides flexibility in that you have control of the pot in future, but it remains subject to investment risk and could run out in future, but you control it on your terms.
What is an annuity !
With an annuity you ideally give you pension pot to your current provider (although you can shop around). In return they will give you guaranteed level of income for the rest of your lifetime. But once it has been purchased it is set in stone and cannot be changed.
The good point is that it creates certainty, protection against any future investment risk. You can just switch off and it does what is says on the tin.
Before the introduction of Pensions Freedom in April 2015, this was your only option, so you were somewhat restricted, but the world of accessing a private or workplace pension in DC format was relatively simple.
How is the amount of income calculated !
Your pension provider will pay an income based on the following assumptions:
- The total size of the pension pot, the bigger the pot the better the level of income,
- Your age, the older you are – the better the income as it pays for a shorter lifespan.
- market conditions – if interest rates are high, then annuity rates are normally higher and are more appealing and attractive to purchase.
- Ill health and medical conditions – if you have existing medical conditions, a provider may pay a higher rate rate (known as enhanced) as they assume you will live for shorter timeframe. Hopefully you prove them wrong, but it’s as assumption they make at the time you purchase an annuity.
Simple illustration:
Pot size of £ 100K, at age 65 in good health – you could take 25% (£25,000) as tax free cash and then receive an annual income of around £ 5,500 per annum. (based on single life basis)
What types of annuities are available ?
Single: will cover an individual for the rest of their lifetime, will normally provide some guarantees for the 1st few years as some kind of protection, but normally dies with them.
Joint: Could cover a partner or spouse again for both their lifetimes. Will provide a lower level of income as you are buying extra provision, but will provide security to spouse, partner.
Enhanced: Will provide a better rate of income if you have existing medical conditions at time of purchase, medical conditions could be HBP, high cholesterol, diabetes, smoking, heart condition etc. Just be honest with your provider by completing some medical questions or providing proof from your doctor or hospital. But unfortunately most people become coy and reserved and not aware that ill-health could increase the level of income payable to you.
Fixed Term: You don’t have to purchase an annuity for lifetime, it could be for a fixed number of years, say 10 / 15 / 20. You may want to enjoy the earlier years of your retirement.
Or you could purchase at say 55 and fund that gap before state pension commences, or DB pensions commence as per the Normal retirement date of that scheme.
With a fixed term, you could make amendments during the term (but check with the provider) and when the term ends it may include a maturity sum. Which could be used to buy another product in future, but be aware rates may be better or worse, or your health could even have deteriorated.
So get some illustrations from your existing provider – one size doesn’t fit all.
How do I access my income from an annuity ?
Your starting point – is to decide if you want to withdraw some tax free cash (currently 25% of the pot). You could take all of it, some of it, or none of it to give you a better income in future. This is normally paid into your back in a few weeks, and then your provider can pay you income on a monthly, quarterly or annual basis as you wish, starting straight away.
Most people choose monthly or ease of budgeting and it’s what thy are happy with, as they would have received any employment income on a monthly basis.
Can I shop around to buy an annuity ?
Most people will stay with their existing provider for ease and they may be happy with that provider. It may be that you have a GAR (Guaranteed annuity rate) on offer, so they give you a better rate of income to stay with them. A common feature on older pensions set up in the 1980’s & 90’s.
You could use a panel of advisers, a hub, IFA or annuity broker. Or some free comparison tools such as that on the money helper.org.uk website. https://www.moneyhelper.org.uk/en/pensions-and-retirement/taking-your-pension/compare-annuities
I believe annuities die with me !
That is a common misconception, but it all depends upon which type you decide to buy.
- single annuity – will provide guarnatees for 1st few years (normally 5) but ultimately will die with you.
- joint annuity – will provide a lower level of income to partner or spouse for their lifetime.
- Fixed term – will provide an income for the complete term, then cease at the end of the term.
- Capital protection – any money left in the pot can pass onto to beneficiaries.
What tax implications do my beneficiaries pay !
If someone dies before age 75 – then any income payable to beneficiaries will remain tax free as long a they act or claim within 2 years. If they fail to act they will then pay tax at their marginal rate and included within any other receive they receive in that tax year.
Someone dies after 75 – then no matter what timeframe any income they receive will be subject to income tax at the beneficiaries marginal rate.
What is flexible access drawdown (FAD) !
With drawdown you money will remain invested in the Stockmarket and continues to go up and down and be subject to ongoing fees and charges. But you can access on a regular or ad-hoc lump sum basis until the pot runs out of money. So ideally you drawdown the pension pot until it is empty.
How do I set up a FAD account ?
Again you can for ease stay with your existing provider, or you can shop around through other pension providers, SIPP providers, IFA or the money helper website using the investment pathways comparison tool being: https://comparison.moneyhelper.org.uk/en/tools/drawdown-investment-pathways
How do I access my money via FAD ?
You starting point is do you access the whole 25% tax-free in one lump sum. Or do you do it in stages, if you have a large pot you could do something called phased or partial drawdown.
You don’t have to start drawing an income straight away, you could do it several years but on your terms. In future you then may access a regular amount each month, ad-hoc lump sums or you may not even access at all, so the funds remain invested.
Simple example: you may access tax-free cash of 25% at age 55 to clear outstanding mortgage, but you may not access the remaining funds until you retire in your 60’s.
Or you could take more money in the early years say you 50’s and 60’s and reduce your income when your state pension commences currently at age 66, soon to rise to age 67.
Your providers will have tools and calculators to assist you, so use them to help you plan your future. But be aware the funds left invested will go up and down, and could run out in future if you access more money in the earlier years.
What restrictions or fees apply !
This will vary between providers, some may say there is a minimum amount you can access each month for admin purposes. Or they may state its a minimum of £ 1,000 each lump sum and it could be limited to 3 withdrawals per year. Another provider may say £ 500 each lump sum and 5 withdrawals each year.
So check in your paperwork with your provider as every institution will have their own fee structure and restrictions in place.
They could also be a free each or dealing charge each time you make a withdrawal, and use the tools and calculators on offer. The pot could run out but it may be 10 / 15 or 20 years in future, but you are doing it on your terms.
Isn’t the idea of FAD complicated !
It may appear complicated, as most people are unaware how drawdown works. As we don’t people how pension products work. You can invest your remaining funds in 3 simple ways:
- Pick your own funds
- Choose something called Investment Pathways
- Use a Financial adviser (IFA) to choose investments and review on your behalf.
What is Investment pathways ?
You can use a simple ready made investing tools on offer called the Investment Pathways. they will be offered to you by a pension provider if you don’t use a financial adviser. In which you should be offered 4 pathways about how you access in the initial 5 years being:
- You have no plans to access with the 1st 5 years
- I intend taking long term income within 5 years
- You wish to draw guaranteed income within 5 years
- The pot will be empty within 5 years
If you do leave fund invested within the drawdown account, get actively involved with it. Where will it be invested based on your attitude to risk, what fees and charges apply. What may the pot be worth in future years, if you don’t decide to access.
What about the tax implications !
Your initial 25% should be tax-free (subject to current limit of £ 268,275) across all your pension schemes. It’s only when you start drawing a flexible income afterwards does it become a tax problem or liability.
If you don’t draw a regular income, on your 1st withdrawal the provider may apply emergency tax code, but they could rebalance on your behalf at the end of the tax year. or you could reclaim quicker by completing relevant form on gov.uk website. The tax is normally refunded in around 30 days.
You could manage your drawdown income very effectively to stay within a certain tax bracket. If you could have no income sources, you could stay as a non-tax payer.
Or if are earning, you may take some income to remain at basic rate of 20% instead of going into higher rate tax bracket being 40%. Either way your provider will tax any income at source, for the vast majority there is no need to complete self-assessment form, or get an accountant or 3rd party involved.
What death benefits apply to drawdown ?
In drawdown, any money remaining in the product can pass onto your beneficiaries, it shouldn’t disappear. But will depend on the rules of the plan with each provider. It could be paid as one-off lump, benefices drawdown account in their name, or the beneficiary could buy an annuity agin in their own name.
If someone dies before age 75 – then any income payable to beneficiaries will remain tax free as long a they act or claim within 2 years. If they fail to act they will then pay tax at their marginal rate and included within any other receive they receive in that tax year.
Someone dies after 75 – then no matter what timeframe any income they receive will be subject to income tax at the beneficiaries marginal rate.
What about inheritance tax (IHT) ?
Under current rules, any money within a drawdown account passed to beneficiaries is currently IHT free in a pension product. Which in recent years, has resulted in pensions being considered very tax efficient with regard to estate planning as they are IHT free. But recent budget announcement, the rule changes in April 2027, so any funds left in the pension pot could subject to both IHT tax rules and income tax rules.
Can I do a combination of annuity and FAD ?
If you have a large pot, you could split that pot across numerous products to get the best of both options. Where some money should give you some security via an annuity and some could be fun money on your terms via FAD.
Or if you have several pensions, you could buy an annuity with a specific pot at age 60, and then do FAD with 2nd pot at age 65.
Thanks to the introduction of Pensions Freedom, it’s up to you what you do with your pensions. The problem for most people is they don’t understand the options available to them and how pensions products work.
If you buy an annuity for lifetime, it is fixed and cannot be changed. Buy you could buy a fixed term annuity, and on maturity move it in drawdown.
Or you start off in drawdown and then later on buy annuity to give you security and peace of mind, or achieve an enhance rate if you develop and ill-health or medical conditions.
What about future contributions ?
Every individual has an annual allowance of £ 60,000 per tax year, or lower amount up to your level of earnings. So if you earn £ 30K, you can contribute 30K per annum including tax relief.
If you buy a lifetime annuity, it’s not a problem. But if you buy a fixed term annuity or access income flexibility via drawdown. You trigger something called the MPAA (money purchase annual allowance) on your 1st withdrawal. Whereby you can contribute to a pension but your allowance is reduced to £ 10,000 per annum.
For most people it’s not a problem, it’s a admin in that you have to let your current DC aware within 91 days.
See my blog post on the MPAA in greater detail: https://moneyminted.co.uk/what-is-the-money-purchase-annual-allowance
Summary: Pros v cons
Annuity pros:
- gives peace of mind and security through guaranteed income
- no future investment risk, no need to constantly monitor
- could get enhanced rate through ill-health or medical conditions
- will pay you for life, never runs out
- interest rates could be high, so annuity income is attractive
Annuity cons:
- once bought cannot be changed,
- may not give a great income if purchased at a young age
- may not provide adequate income to spouse or partner
- a small pot may not provide sufficient income
- may not be passed onto beneficiaries.
FAD pros:
- You are in control of the money on your terms.
- you have greater level of flexibility on how and when you access.
- investment pathways investment exist to help people manage their funds
- You can change your plans in future years
- Any funds left in the pot will pass to beneficiaries
FAD cons:
- Your pot isn’t guaranteed could go up and down
- the pot will run out in future
- will be subject to ongoing fees, charges and investment risk
- your investments need constantly reviewing
- by triggering MPAA, you may restrict future contributions
If you need help about your pension options and which option to take. Take advantage of the free and impartial help on offer by booking a Pension Wise appointment. Its usually last up to 1 hour, and discusses the 6 options available to you in greater detail.
use the link: https://www.moneyhelper.org.uk/en/pensions-and-retirement/pension-wise or cal them on 0800 138 3944. If you don’t want a full appointment call the free helpline on 0800 011 3797.
Remember: If you found this blog post useful and informative, then out out my other posts on pensions, savings investing and investment books I recommend on https:moneyminted.co.uk
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