Annuities explainedAnnuity alternatives

You can't change your mind once you've bought an annuity, so you might want to investigate the alternatives

Most people buy an annuity when they retire, but there are several reasons why you might want to defer buying one including poor life expectancy or worries that imminent rate rises will see you lose out on money.

Before April 2006 you had to buy an annuity by age 75. Now it is possible to avoid annuity purchase altogether by using 'income drawdown' to age 75 and 'alternatively secured pension' after it.

This is a flexible way of providing a pension, but carries extra costs and risks. If you're thinking about deferring or avoiding annuity purchase, you are seriously advised to take independent financial advice as this is a very complex area.

Income drawdown

With income drawdown, you take an income direct from your pension fund while leaving it invested. The idea is that investment growth will keep your fund healthy.
Income drawdown gives you considerable flexibility over how much income to take - you can choose to take no income at all or up to 120% of your available annuity income. You can choose at any time to stop drawdown and buy an annuity instead.

If you die during income drawdown your heirs can inherit the remaining fund. The remaining fund can be paid to them as annuities, or as income from the fund which is then taxed. Alternatively, it can be taken as a cash sum less 35% tax.

Alternatively Secured Pension

Once you reach age 75 you must either buy an annuity or opt for the new alternatively secured pension (ASP) to keep your money invested. Effectively, ASP is a more limited form of income drawdown. You can choose to take no income at all or up to 70% of your available annuity income.

When you die, any remaining pension fund is used to provide a pension for a dependant. It can't go to your estate. If there are no dependants, you can pass your pension fund on to friends and family members' pension funds.

It is unclear currently how this will work in practice. It is clear that inheritance tax at 40% will apply to any pension fund remaining at death, unless it is used to provide pensions for dependants or given to charity.

Be mindful of risk, it's your life savings at stake

The risks

Going into income drawdown and then ASP carries serious risks. : Whilst annuity rates are currently at an unexpected high – over the past few years they have fallen heavily. This could mean that you will have to buy at a lower rate when you eventually buy an annuity. You also miss out on the income you could have gained in the meantime.

Remember annuities are based on a cross-subsidy where people with poor life expectancy subsidise those who live to 100. If you retire at 60 but buy an annuity in your early 70s, you miss out on the cross-subsidy from all those who've died in the meantime.

There is the risk your pension fund's value could fall over time. This is partly because of the inevitable capital risk associated with investments, and partly because if you take an income from your fund, the remainder has to work that much harder to keep up.

There is also the impact of charges to consider. Once you've bought an annuity you don't have to worry about charges anymore. With income drawdown and ASP you have investment management charges for your investments, administration charges for your drawdown plan, and also the cost of periodic reviews to work out how much income you can take.

Because of what's at stake, income drawdown and ASP are only suitable if you have a large pension fund of £100,000 at the very least, and preferably some other income.