Martin Lewis compares pension annuity against drawdown
An annuity is a guaranteed income for life that people buy with their pensions. Before 2015’s pension freedom reforms, retirees were obliged to buy them. Demand crashed once that obligation was removed, as ultra-low interest rates made annuities look poor value and many pensioners considered them inflexible as buyers are locked in for life.
Today, most retirees prefer to leave their pension invested via drawdown. However, annuities now look a lot more tempting, thanks to rising interest rates.
A 65-year-old with £100,000 of pension can get income of more than £7,000 a year. That’s up from just £5,000 only two or three years ago.
That’s a difference of more than £2,000 a year which adds up to £40,000 in total extra income over a typical 20-year retirement.
The big advantage of an annuity is that the income is guaranteed for life, no matter how long you live, avoiding the danger of running out of money.
This is less risky than drawdown when funds can run out if stock markets crash or you make too many withdrawals.
Millions flirted with a potential drawdown disaster during recent stock market volatility, as they watched the value of their retirement savings fall.
If someone decides an annuity is the right option for them, they face a tough decision. Should they choose a level annuity, where the income stays the same throughout the term, or an escalating annuity where the income rises every year to keep pace with prices?
Typically, escalating annuities either rise in line with the retail price index (RPI) or click up at a fixed percentage of three per cent a year.
It may sound like a no-brainer. Surely it’s better if your income rises every year to keep up with inflation? The problem is, the escalating income starts from a much lower base.
Level annuities pay a lot more in year one, and most people choose this option even though it means their spending power will decline over time.
So which option is best?
Researchers have crunched some numbers and come up with a definitive answer
Today, the typical 65-year-old with a £100,000 pension would get level annuity income of £7,175 a year.
If they chose a pension that escalated by three percent annually, their year-one initial starting income would fall to £5,185 and a mere £4,279 for one linked to RPI.
Now experts at Canada Life have worked out that it takes more than two decades to make good the initial income sacrifice.
Incredibly, it would take 22 years before the three percent escalating annuity has paid more in total income than the level annuity. At this point, it would have paid £158,357 in total, finally overtaking the level annuity’s £157,856.
The RPI-linked annuity would only have paid a total of £146,558 at this point. It will trail the level annuity total for another four years.
After 26 years, the RPI annuity would have paid a total of £189,624, belatedly topping the level annuity’s £186,557.
Yet it will have fallen even further behind the three percent escalating annuity. This would have paid £199,928 in total and been the best option for those who lived a long time after retiring.
To put it another way, someone who chose an escalating annuity at 65 would have to wait until they were 87 to beat the level annuity, or 91 if they chose an RPI-linked annuity.
Of course, these figures may vary in future, depending on how high RPI is. Obviously, nobody can say.
It’s clear that in most cases, annuity buyers will be better off with the higher starting income, said Canada Life’s retirement income director Nick Flynn. “While it’s easy to get lost in the myriad of options of available on annuities, one thing appears to be a sure-fire bet. For most people, choosing the certainty of a level income is likely to be the best decision.”
Flynn suggests that a combination of level and escalating annuities could also work well. If choosing this option, Canada Life’s figures suggest the three percent deal is better value than the RPI one.
Buying an annuity is still complex, so consider financial advice.
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