These days, most people have more choice than ever before when it comes to using their pension pot. Annuities remain one of the options and here we explain how they work and when they can be a good option.
What is an annuity?
An annuity is a product that pays a guaranteed income – usually monthly – for at least as long as you live. You can buy one with some or all of your pension pot, or with your savings.
The amount of income you get from an annuity depends on how much money you use to set it up, plus other factors such as your age, health and lifestyle when you take it out. You can use it to provide for loved ones by setting it up to continue paying an income after you die, although this will reduce the annual income you yourself receive.
Once an annuity’s up and running, you can’t usually make any changes to it, swap it or get your lump sum back. So it’s important to do your homework and know exactly what you need from an annuity before committing to one.
Annuities as a lower risk option
It’s possible to keep your pension invested and withdraw a flexible regular income that covers your essential costs. This is called income drawdown or sometimes flexi-access drawdown.
While keeping your pension invested and using income drawdown could potentially provide a higher income, the opposite might happen, and you could end up with less income than you would’ve got from an annuity.
Remember that the value of investments can go down as well as up and you could get back less than has been paid in. If your investments don't grow enough to cover your spending needs, there's a risk that you could run out of money.
If you're not comfortable with taking a risk with your money, this makes an annuity can be a good choice. Some people are more comfortable with the option that provides a guaranteed income, even if they are less flexible.
Downsides of an annuity
An annuity isn’t going to be right for all situations or tastes. The potential negatives are:
- Inflation will reduce the spending power of the annuity income over time. You can offset some of the effects by buying an annuity that increases each year, but if you do this your annual income will start lower than an annuity which only pays a level income.
- Once you buy an annuity, you can’t change any features or get your money back out if your circumstances change.
- If you don’t add an income guarantee or spouse’s pension, the income paid by the annuity stop when you die.
- Depending on how long you live, you might get back less from an annuity than you paid for it.
- Unlike income withdrawals directly from an invested pension fund, you can’t alter the amount of income you receive as your requirements change over time.
A mix sometimes works best
You don’t need to use all your retirement savings to buy an annuity. You can put some money into income drawdown (or make one-off withdrawals from your pension fund) and buy an annuity with the rest.
In fact, a blend of withdrawals from income drawdown and predictable income from an annuity can often provide the optimal trade-off between the security of a guaranteed income and the risks inherent in trying to maximise returns on your investments.