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Cash, annuity or drawdown: which is best for you?

This 'options matrix' will help you work out what to do with your pension.

 

by Michelle McGagh on Nov 19, 2015 at 08:00

Cash, annuity or drawdown: which is best for you?

Deciding what to do with your pension is trickier than ever but by answering a few simple questions about your health, your home and inheritance plans could make it a lot easier.

Since April, over-55s have been free to use their defined contribution (DC) pension as they wish. They can take it all out as cash (minus the income tax), they can buy an annuity which pays an income for life (but at typically poor rates), or they can keep it invested through drawdown and take income when they need it (but risk running out of money).

Each option has pros and cons and many retirees are trying to navigate the decision alone as they are either unable or unwilling to pay for financial advice.

The International Longevity Centre-UK has published a report that could help individuals make the right decision with their money, based on a simple ‘options matrix’ that sets out the best solution depending on an individual’s circumstance.

Les Mayhew of the Cass Business School, who wrote the report, said any option came with risks but retirees needed to consider their health, their home and whether they wanted to pass money on after they die, in order to determine what to do with their pension.

Those in poor health received better annuity rates through ‘enhanced annuities’, also known as 'impaired annuities', because ‘poor health affects longevity and therefore value for money of an annuity’, said Mayhew.

If a retiree is a homeowner, this provides more security as they could release equity from their home to supplement their pension if they need to. The average homeowner aged 65-plus in the UK has £122,000 of equity in their property ‘which is much higher than the average pension pot’.

‘Downsizing can be a source of additional funds as long as there is no significant debt,’ said Mayhew. ‘However, if the individual’s health or mobility has deteriorated, equity release may be a more practical option.’

And finally, those wanting to pass money on to children or grandchildren should take this into consideration when retiring. Under the new rules individuals can pass on their pension to whoever they like, as long as it is in drawdown, while annuities cannot be inherited.

The following chart should help individuals determine whether turning the pension into cash, buying an annuity  or going into drawdown  is the best option:

Person type In poor health Home owner Bequest motive Cash Drawdown Annuity
1 Yes
2 Yes Yes Yes
3 Yes Yes
4 Yes Yes Yes
5 Yes Yes Yes
6 Yes Yes Yes Yes
7 Yes Yes Yes Yes
8 Yes Yes Yes Yes Yes

Source: International Longevity Centre-UK

Person 1: has good health, no home so they must pay rent, but no ‘bequest motive’. This means they would be best to annuitise ‘unless they have a very large pot that is unlikely ever to be exhausted'.

Person 2: is like person 1 but in poor health so their life expectancy is reduced. If they can buy an enhanced annuity this is the best option but ‘if this is not available to them, then drawdown is likely to be a better option’, said Mayhew.

Person 3: the same as person 1 but owns a home. ‘If they have outstanding mortgage, they could use some of their pot to pay this off,’ he said. ‘With a mortgage-free home, drawdown is likely to be a better option, since they can always release equity from their home later.’

Person 4: is the same as person 1 but wants to pass money on. They could withdraw money while they are still alive to help their children but ‘they could also purchase a joint annuity with their partner so that both their income needs are met even after one dies’, said Mayhew.

Person 5: is in poor health and a homeowner. This allows them to take more financial risk, said Mayhew. ‘They may be able to secure an impaired annuity at a higher rate, but they are probably better off using a combination of income drawdown and equity release,’ he said.

Person 6: is in an ‘awkward position’ because they want to leave money behind but do not own a home and are in poor health. ‘The main danger is using up all of their assets before they die with nothing to pass on,’ said Mayhew. ‘In principle they could gift money before death, but they may leave themselves short of cash unless they buy an impaired annuity.’

Person 7: they have access to housing equity so could gift money early knowing they have the opportunity to release equity later. ‘With the home providing financial security and also a source of funds to bequeath, this person may choose income drawdown based on their shorter life expectancy,’ said Mayhew.

Person 8: whether this person can access an enhanced annuity will impact the annuity decision. ‘With the home providing financial security and also a source of funds to bequeath, this person may choose income drawdown based on their shorter life expectancy,’ he said.

Mayhew added that individuals should also consider what state pension they would receive, any defined benefit pension streams, and whether they were in a couple.

‘You can take more risk with your pension pot if you have a defined benefit pension and the state pension or you live in a couple because you have a lot more income streams,’ he said.

Steven Baxter of pension consultants Hymans Robertson said any retirement strategy ‘had to balance competing needs’.

‘You need stability to cover basic bills and flexibility to cover other financial shocks, but you also need to protect yourself from financial ruin [caused] by spending all your money,’ he said.

‘The drawdown approach is likely to be the best option [in a number of scenarios] but if protection is your premier concern than the reasons to buy an annuity grow.’

While those in a privileged position of owning a property undoubtedly have the better outcomes, Jackie Wells of the Pensions and Lifetime Savings Association warned people that their property would not pay for everything and not to expect too much of it.

‘Equity release may not be available to everyone and it is not clear everyone should do it,’ she said.

‘People do have this view that their property will do everything for them; fund their retirement income, be a place to live in, pay for care, and leave it to the children. We need to do some work showing them it cannot do all these things.’

2 comments so far. Why not have your say?

Pilgrim

Nov 21, 2015 at 19:29

Simplistic, and poorly thought out.

For example, the advice for Person 1 to 'annuitise'.

This strategy makes no provision for the effect of rents increasing over time. Locking in to a level annuity would result in a leveraged reduction in disposable income as the rent and the costs of living increase under the effects of inflation. Infirmity and impoverishment then arrive together.

The selection of an index linked annuity would counter this risk, but the level of income available is then set at a much lower level. A well diversified pension fund, combined with a prudent drawdown policy provides a measure of inherent inflation protection, and is capable of adjustment to reflect changing needs at any time in the future.

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Maverick

Nov 21, 2015 at 23:32

Do bear in mind that the International Longevity Centre is in fact funded by many annuity providers : Aviva, Legal & General, Partnership, Prudential, etc - see its website.

The website invites further organisations to become "Partners", saying "Membership will help you nudge or shape policy development."

So it is not altogether surprising that the report recommends annuities.

Cynical? Me???

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