Annuities explained Annuity alternatives
You can't change your mind once you've bought an annuity, so you might want to investigate the alternatives
Before April 2006, you had to buy an annuity by age 75. After ‘A’ Day it became possible to avoid annuity purchase altogether by using 'income drawdown' to age 75 and 'alternatively secured pension' (ASP) after it.
In June 2010 the rules changed again. The government increased the maximum age for income drawdown from 75 to 77. In April 2011, it abolished the age limit altogether, permitting individuals to stay invested in drawdown indefinitely. This did away with the need for alternatively secured pensions (ASPs). Individuals with an existing ASP are obliged to switch to the new drawdown system (see below) or buy an annuity within 1-5 years under transitional provisions.
Drawdown is a flexible way of providing a pension, but carries extra costs and risks. If you're thinking about deferring or avoiding buying an annuity, you're 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.
Capped drawdown
Income drawdown gives you considerable flexibility over how much income to take. In a standard ‘capped’ drawdown scheme you can choose to take no income at all, or up to 120% of the limit set for your age by the Government Actuary's Department (GAD). Before March 2012, the maximum income was 100% of this limit, having been reduced from 120% in April 2011's Budget. This extra 20% amounts to a fifth more pension 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,both of which are taxed. Alternatively, it can be taken as a cash sum less 55% tax.
Flexible drawdown
From April 2011, the government has relaxed the rules on pension withdrawals for those who are eligible to enter Flexible drawdown. Rather than capping your pension income in line with GAD limits, Flexible drawdown allows you make any withdrawals you like. To be eligible for this type of drawdown, you must meet the newly established Minimum Income Requirement (MIR).
To meet the MIR, you must already be in reciept of pension income of at least £20,000 a year (the minimum income), from other registered pension schemes (such as employer final salary schemes, lifetime annuities) and/or state pension. Payments from your drawdown scheme don’t count towards this.
The risks of income drawdown
Going into income drawdown and staying invested beyond 75 carries serious risks. Though there may be short-term rises in annuity rates, on the whole they have fallen heavily over recent years and could drop further in the future. This could mean that you will have to buy at a lower rate if you eventually buy an annuity. You also miss out on the income you could have gained in the meantime.
Remember that annuities are based on a cross-subsidy, where people with poor life expectancy subsidise those who live longer than expected. 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 a risk your pension fund's value could fall faster than expected. This is partly because of the inevitable capital risk associated with investments, and partly because as you take an income from your fund, the remainder has to work that much harder.
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, 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 is only suitable if you have a large pension fund, and preferably some other income.
Be mindful of risk, it's your life savings at stake
Small pension funds
If you are between 60 and 74 and your total pension scheme savings are worth less than £18,000, you may be able to take the whole amount as a lump sum, known as trivial commutation. It will be taxable in part.
You can use this money however you want. For example, you could use it for day-to-day living costs or put it into a savings account until you need it. Alternatively, you could buy a purchased life annuity with the cash (see the annuity types types section), though some annuity providers impose a minimum limit on the amount you can invest in an annuity, so you may struggle to get the best rate.
Phased retirement
You don't have to invest all your pension fund in an annuity at once – an alternative is to stagger your annuity purchases over a number of years.
- For a personalised solution, call our experts on the Which? Money Helpline
- Take a look at our expert guide to writing a will
- For more information on the best options for you, read our guide to planning your retirement
