The benefits of a blended approach to annuities and drawdown

Important information - the value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

Could the party come to an end?

However, the Bank of England has been trimming interest rates and is expected to continue doing so. This could dampen interest in annuities, as rate cuts would eventually reduce gilt yields and, by extension, annuity rates.

What’s more, deciding whether to purchase an annuity or to access your pension via drawdown (the other main option) is an extremely complex and individual decision that involves carefully weighing up the pros and cons. Rather than going for an either/or decision, some investors opt for a blend of the two.

Here we run through the options available.

The pros of annuities

One of the key benefits of annuities over drawdown is security over your income.

If you go for a lifetime annuity, it will guarantee to pay you a set income for life. With drawdown, you do not get a guaranteed income. Instead, you leave your money invested and take a regular income direct from the fund.

The latter means your pension pot can still benefit from stock market growth, unlike an annuity which is fixed. However, it also means that, if stock markets fall, the value of your pot falls - so you either need to draw less from it or accept that it will run out faster.

Aside from security over income, now that unspent pensions wealth is coming into the scope of inheritance tax (IHT), there may be additional benefits to taking out an annuity.

• Read: Inheritance tax changes - what we know so far

Previously any unspent money in a drawdown pension could be passed on after death without incurring IHT. However, this is set to change in April 2027.

Families wanting to pass on pensions wealth after this point might consider buying an annuity and using an IHT allowance called ‘gifting from surplus income’. This rule allows people to gift a potentially unlimited amount to their loved ones, provided they adhere to the following:

1. The gifts must be made out of your income.
2. They must be paid on a regular basis and become part of your ‘normal expenditure’.
3. Making these gifts should not impact your current standard of living.

The cons

There are also various downsides to opting for an annuity over drawdown.

Firstly, you lose flexibility. With drawdown, the amount of money you take each year is completely up to you - giving you the option to take less or more as you need.

Secondly, drawdown has the benefit that your money remains invested in the stock market so, if markets go up in value, the value of your pension pot continues to grow.

Buying an annuity is an irreversible decision, so it is not something to undertake lightly.

Many annuities also face a threat from inflation. A level annuity pays the same amount each year, regardless of inflation. If prices rise, then the value of your income decreases in real terms.

You can get an escalating annuity, where your income goes up each year by a fixed amount, say, 3%. Or you can get an inflation-linked annuity, which goes with the Retail Prices Index (a common inflation measure) each year - however rates for these will generally be lower than for a level annuity.

The benefits of a blended approach

Given the various pros and cons to juggle, some retirees prefer to take a blended approach - using some of their pension to buy an annuity and leaving the rest in drawdown.

If done appropriately, this combination can give retirees security over things such as essential spending and provide insurance against longevity risk while also enabling them to continue benefitting from investment growth and flexible access to their money. 

According to Charlie Nicol, from Fidelity’s financial advice team, each situation will be individual and so there is no “one size fits all” approach to retirement planning.

“First, we get to know our clients, which includes assessing their risk profile: how do they perceive risk? What’s their financial capacity for taking risk? Then we look at what the client has in terms of pensions wealth and how much income they need in retirement,” says Nicol.

“This income will typically fall into two categories, essential expenditure and discretionary expenditure. Some clients have a preference to ensure their essential spending is underpinned by guaranteed income, like the state pension, defined benefit income or a lifetime annuity. This is where a blended solution could work.”

One potential option, he adds, is to consider underpinning your essential spending with guaranteed income.

This can provide the client with some comfort in knowing their minimum needs are met and in turn potentially help increase their capacity for loss when it comes to their remaining investments in drawdown, assuming they have the risk appetite. This means you can avoid having to put all your eggs in one basket and provide a blend between security and flexibility.

However, there are numerous factors to consider when researching a lifetime annuity, including a person’s health.

“Annuity rates are completely tailored to the individual, even down to height, weight and postcode,” Nicol explains. “A current standard single life, non-increasing rate for a 65-year-old might be in the region of 7% but if you’ve got a medical condition, such as diabetes, high cholesterol, etc. it could be higher depending on the severity of the medical condition.”

This is why it is important to explore fully the annuity rates from the open market and disclose any lifestyle or medical conditions before deciding.

Death benefits also need to be considered. It is possible to include features that allow for some or all of your funds to be returned to your beneficiaries upon death.

“Whilst this will impact the annuity rate, sometimes these features don’t cost as much as you would think and can provide peace of mind,” Nicol adds.

Other blended strategies

Some retirees go for a staged annuitisation. For example, you could buy a small annuity at 65 to underpin your essential spending, leaving the rest invested via drawdown, and then take out another annuity later in life. At this point, rates are typically higher because your life expectancy is shorter.

Fidelity’s financial advice team has seen growing interest in a lesser-known product: a fixed-term annuity.

This is where you hand over some or all of your pension pot to an insurance provider over a fixed term who will guarantee an income (if needed), plus, at the end of the fixed term, after you’ve received those income payments, you get a guaranteed maturity value back too.

For instance, at age 60 you might want an income of £11,937 (equal to the current state pension) which increases by 2.5% per annum to bridge the gap to state pension age. You might give the insurer £500,000 (after payment of tax-free cash), and they promise an income of £11,937 gross per annum (increasing by 2.5% per annum) from 60 to 67 plus a guaranteed maturity value at the end of the term of £585,620.²

“The rates for fixed-term annuities have been attractive recently due to underlying interest rates,” Nicol says. “It’s not fully flexible like drawdown, as you generally can’t change the income once set up or access the capital during the fixed term. However, you are provided with a guaranteed income and maturity value at the end of the plan, which is not subject to stock market risk. The maturity value allows you to then reconsider your options at that time, whether you decide to purchase a lifetime annuity, move into drawdown or even purchase another fixed-term annuity. Should you die within the term, it is possible to include death benefits to protect your capital.”

Income in retirement is a very complex area of financial planning. The government’s Pension Wise service offers free, impartial guidance to help you understand your options at retirement. You can access the guidance online at www.moneyhelper.org.uk or over the telephone on 0800 138 3944.

If you’re unsure of anything, it would be worth speaking to a qualified financial adviser. If you have over £100k invested (this includes your pension) our financial advisory service can help. The initial conversation with a Fidelity adviser is free and there’s no obligation, it’s simply a chat to see if financial advice might be right for you. 

• Learn about financial advice
• Read: Inflation scenarios: what 3.8% rate does to a pension
• Read: 6 ways to fix your finances for the 100-year life

Source:

¹ Based on a 65-year-old in good health purchasing a single life annuity with no annual increases and a five-year guaranteed period. The purchase price is £100,000 and the 65-year-old has an Isle of Wight postcode.
² Based on rates as of 10.9.25.