What are my pension income options?

This week’s article focuses on Defined Contribution (also known as Money Purchase) pensions only, as they are the most common form of private pension provision in the UK today. The following excludes Final Salary Pensions and the State Pension.

Before I start, what is a Defined Contribution pension? Well, in its most simple form, it is a long-term savings account, which will be required in future to provide an income, to replace earnings once you have stopped working. The larger your pension pot at retirement is, the more income it will provide you for the rest of your life.

Broadly speaking, there are two main options: a ‘Lifetime Annuity’ and ‘Flexi Access Drawdown’ (FAD). There are other hybrid type products available, but these two are by far the most common. It is worth noting, that it is not a case of selecting one or the other, you can split your pension savings to have a bit of both.

With both these options, you are entitled to 25% of the pension pot tax free. However, the way on which you can take this differs across the products. The remaining 75% is taxed at your marginal rate upon withdrawal.

These options are very different and choosing the right path is one of the biggest financial decisions you will ever make. Remember, this will provide your income for the rest of your life which could be 30-40 years. If you are unsure, this is the time to seek advice from a professional who will recommend the most suitable product for you.

I can’t tell you which is best, as it is purely down to your personal circumstances as to what is most suitable. What I will provide is a high-level overview, highlighting the positives and negatives of each option.

Option 1: Lifetime Annuity

This is effectively a life assurance product, whereby the annuity provider, using health statistics, will attempt to guess your life expectancy and will pay you a guaranteed income for life, in exchange for a large lump sum (your pension pot).

To give a simple example; a healthy 65-year-old might be expected to live for 20 years. Therefore, in exchange for a £100,000 pension fund, the annuity provider makes a promise to pay £5,000 income per year, guaranteed, until the individual dies.

Each individual is underwritten on their medical conditions and the sicker you are, the more income you will receive - this is to reflect a shorter than average life expectancy. This is the only time you want to be sick when underwriting an insurance policy! Using the above example, lets assume that the individual was overweight, a heavy smoker and recently had a heart attack. The annuity provider instead estimates the life expectancy to be just 10 years and will therefore pay an income of £10,000 per year, rather than the £5,000 which a healthy person would get.

The above is a simple example. Like all insurance policies, there are other features you can include, but the more of these you add, the lower your income payment will be. These features are:

• Indexation. You can ensure the income increases every year to keep pace with inflation. You can choose to have this fixed at a certain percentage (e.g. 3%) or to a specific index such as RPI or CPI. Alternatively, you can keep it ‘level’ meaning it will remain the same throughout.

• Dependents pension: You can select a percentage at the outset such as 50/67/100% which your dependent (doesn’t have to be a spouse) will receive as guaranteed income following death. If the annuitant was receiving £5,000 per year and had a 50% spouses’ pension, following death, the spouse would receive £2,500 per year until death.

• Guarantee period: This guarantees that the full income will get paid for the remainder of the guarantee period, should the annuitant die earlier than expected. If the annuitant had set up a 10-year guarantee period and died after 4 years, the annuity income would continue to get paid to the estate for the remaining 6 years.

Best annuity rates today using a healthy 65-year-old, spouse 3 years younger. £100,000 pension fund:

- Single Life/level/nil guarantee (most basic): £4,785 pa
- Joint Life 100%/level/nil guarantee: £3,776 pa
- Single Life/RPI/nil guarantee: £2,681 pa
- Single Life/level/10 year guarantee: £4,720 pa

To summarise:

Positives:
• Pays a guaranteed income for life, even if you live to 150.
• No investment risk.
• Simple to understand/no requirement for ongoing advice.
• No ongoing charges.
• A range of features available to suit your circumstances.

Negatives:
• You lose financially if you die earlier than expected.
• Once annuity is set up, it cannot be changed. It is completely inflexible.
• The annuity dies with you, or your dependent, so cannot be passed to your descendants.
• Loss of a capital lump sum at the outset which will have no opportunity to benefit from potential investment growth.
• The 25% tax free cash must be taken in its entirety as a lump sum at the time of purchasing the annuity.

Option 2: Flexi Access Drawdown (FAD)

This option has become far more prevalent since the introduction of Pension Freedoms in 2015. With FAD, you can simply draw as much or as little income as you want, whenever you want. This comes with an element of risk.

Imagine a bucket of water. The water in the bucket represents your pension life savings. Whilst it remains in the bucket, it is invested and benefits from tax free investment growth. Upon reaching retirement, you fix a tap to the bottom of the bucket. Whatever comes out of the tap is your income. You can turn this on/off whenever you like, but the danger is that the water in the bucket might run out in future.

There are no income rates to show for FAD, like there are with a lifetime annuity. Scientific analysis believes that a 4% withdrawal rate would be sustainable for life (withdrawing £4,000pa from a £100,000 fund).

This might seem quite straight forward from the above analogy but is far more complex than an annuity as I will explain.

Positives:
• Completely flexible. Income can be adjusted to suit circumstances.
• Access to capital lump sums.
• Tax efficient. For example, income can be tailored so that it doesn’t exceed a certain tax threshold.
• The 25% tax free cash doesn’t need to be taken at the outset. It can remain invested and can be drawn out in smaller parts when required. It can even be used for additional regular withdrawals to supplement other income.
• On death, the remaining pension can be passed to anybody. Furthermore, this will be tax free if death occurs before age 75. If death occurs after age 75, it will be taxed at the recipient’s marginal rate.
• Remaining pension will sit outside of the estate for IHT purposes. It’s one of the best vehicles for inter generational wealth planning.
• Opportunity to benefit from investment growth (it can also go down).
• You are not locked in. You can still purchase an annuity in future if you desire.

Negatives:
• More complicated – it is always recommended that you take ongoing financial advice.
• Charges apply. These include pension administration, investment charges and IFA charges (these vary, likely to be 1.5%-2% per annum in total of the pension value)
• Investment risk. Investments can also go down as well as up. Coronavirus would be a daunting time for those in FAD.
• No guaranteed income. If investments perform badly and/or you live longer than expected, you might run out of money in future.

Arranging your pension income is one of the biggest financial decision you will ever make as it might need to last you for 30-40 years

As ever, please ask or pm me if you have any queries.

On this point, the industry came under heavy scrutiny several years ago as providers were making it too easy for retirees to simply accept the first annuity rate being offered to them.

This meant that retirees were not shopping around for the best rate and losing out on millions of pounds of income. It is so important to shop around and speak with an Adviser when reaching retirement.

Guaranteed income (annuity) and Drawdown often compliment each other well. Some people like to have a baseline of guaranteed income to cover their 'essential' expenditure, such as bills and food. This can be from a combination of State Pension, annuity and final salary pension. The rest of the pot (Drawdown) can simply remain invested and be used to dip into occasionally for large ad-hoc costs such as holidays, gifts and new cars.

Morning Cryrst, no worries, just call when you're free.

Yes, you are correct in your understanding.

The mechanics would work as follows: You would need to 'crystalise' £20,000, of which 25% is your £5,000 tax free amount. The other £15,000 would be designated to drawdown, where you could either withdraw it as taxable income or leave it invested to grow.

The remaining £80,000 of 'uncrystalised' pension can remain invested. Let's assume over the next 5 years this grows to £90,000, you would then in future be entitled to 25% of £90,000 (£22,500). Like before, you don't have to take it all in one go.

Mr Goal Machine,

You say that if the pensioner dies before age 75, what is left of his pension will be taxed at the recipient's marginal rate - which could be up to 45%. That seems to mean that a widow "inheriting" a pension pot of £400k could immediately have to give at least £80k, and up to £180k, of that sum to the tax man. I have always thought it was only the recipient's withdrawals from the pot that were taxed. Could you please clarify?

PS: Do you ever regret starting this thread?!

Mr JRW2,

Ha! No, I don't regret (yet!). Hopefully people are getting some benefit out of the thread. You never know, if someone would like help from an IFA one day, they'll think of me.

When the pensioner dies before 75 it can be withdrawn tax free by the beneficiary.

Using your example, when the pensioner dies after 75, it will pass to the widow tax free, but will be taxed at the widows marginal rate upon withdrawal - this could be 0% / 20% / 40% / 45% depending on their situation.

So yes, you are correct. Just had the before/after 75 the wrong way around.

GM I appreciate the response. It certainly sounds like the charges will be a barrier. I am in a fortunate position that between my wife and I we have 3 decent final salary pension schemes and 2 cash buyout pots. So I suspect we will leave them as they are maximising the monthly income, and using the cash funds as flexi draw downs. Congrats on a very interesting and useful thread.