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Guide to Retirement IncomeThe pros and cons of different retirement income options
A lifetime annuity is comparatively inexpensive - though rates have dropped in recent years - and has the benefit of a known level of income guaranteed for life. The lack of investment risk can be seen as a great benefit.
However, conventional annuities have a lack of death benefits and lack any flexibility if circumstances change.
Most importantly, with more than 90 per cent of guaranteed annuities in the UK being set up as a level income, there is no opportunity for further investment growth and inflation is a key threat reducing income each year in real terms, points out Andrew Tully, pensions technical director at MGM Advantage.
“As many people can now be in retirement for 25 or 30 years, 3 per cent inflation for 20 years will nearly see income half in real terms.”
Drawdown, on the other hand, provides a number of benefits. The key trade off is the loss of any income guarantee.
Drawdown is much more flexible, offering the ability to change income at any time to meet changing lifestyles or for tax management, while also hopefully benefiting from investment returns from a flexible choice of investments. An annuity can be bought any time, too.
Drawdown also offers good death benefits, with funds returned to the client’s estate on death, less tax, or alternatively used to provide drawdown or an annuity for a dependant.
On the downside for drawdown, income can fall if funds do not perform well, as many drawdown customers have experienced over the last few years. Moreover, health and lifestyle are not taken into account.
As drawdown does not benefit from mortality cross subsidy, the risk of being in drawdown increases as people get older.
To mitigate this, many people begin in drawdown and move to some form of annuity as they get older. The risk of this approach is that interest rates may fall, which could lead to a smaller annuity than could have been bought at outset, according to Fiona Tait, business development manager at Scottish Life.
Also, if maximum income is taken, the plan value could fall and reduce the amount of any annuity bought or the death benefits available.
In terms of alternatives to standard annuities and drawdown, there are a number of third-way options – like variable annuities and fixed term annuities – which provide more flexibility than annuities but less than drawdown.
Investment-linked annuities try to offer the best of both worlds, but have their disadvantages too.
This option gives clients the ability to choose starting income from a range and vary it on a regular basis, while benefiting from investment returns. As an annuity, the exact shape needs to be chosen at outset, but being an annuity means health and lifestyle are taken into account.
Mortality cross subsidy means these are lower-risk products than income drawdown, currently needing an investment return of around 3 per cent a year to match a conventional annuity, says Mr Tully.
