5.4 Understanding your pension options
In this section you’ll learn more about the pension options introduced in the previous section.
First, watch this video where Emma Byron of Legal & General introduces these options.
Now watch these three short videos which explain the options for using a pension pot. Then check your understanding by working through the activity below.
Activity 3 Exploring your pension options
Having looked at the options for using a pension pot, what do you think are the pros and cons of choosing:
- A guaranteed income for life (an ‘annuity’)?
- A guaranteed income for a set period?
- A mixture of these options?
A guaranteed income for life (an annuity)
Choosing a lifetime annuity provides certainty about your pension income as it pays out a regular fixed income until you die. This will mean you can check, with confidence, how far it will go to meet your spending in retirement.
There are additional features available on annuity products such as inflation-proofing the payments, protecting some or all of the money used to buy your annuity, or ensuring your spouse or dependant continues to receive some or all of the income should you die before they do. Having health issues could increase the return you can get, so disclosing your health and lifestyle details may mean you qualify for an enhanced annuity. And do shop around for the best annuity deal as what you can get varies between annuity providers.
As people are living longer and long-term interest rates have fallen, annuity rates have reduced in recent years, but they are guaranteed. Also, buying an annuity is a very important decision which can’t be reversed.
A guaranteed income for a set period
Taking your pension pot through a fixed term plan is a good way to provide certainty about your retirement income for a set period of time. This could be a tax-efficient way to use your pot – particularly if your total income each year is no more than your personal (tax-free) allowance. Some of these products pay a fixed amount through the term and others offer a lump sum at the end of the term as well as regular payments. This lump sum payment can then be used to purchase another retirement income product or taken as cash depending on your circumstances and the amount payable.
The downside is that these plans have a set term – and at the end your pot may be used up and you will get no more pension income from the plan. This could mean that you have less income than you need in later retirement.
Choosing drawdown provides more flexibility with how much cash you can take, and when, from your pension pot. This will help you manage those periods when your spending increases (for example, bills for home maintenance). This might also be useful if you’d like to access the tax-free cash amount from a pension pot. With drawdown your money is invested in your name and therefore you are responsible for managing the investment and the amount you withdraw. You would be susceptible to financial market lows as well as benefiting from the highs. If you spend money too quickly you could be short of money later on in retirement.
A mixture of these options
You may want to use different options if you have more than one pension pot. You may choose to take a larger lump sum at the start of your retirement to pay off debts, or to spend on major projects and plans (e.g. a world cruise or on renovations to your home). You could then use other pensions to provide that regular income you need to cover routine annual spending – perhaps using your state pension to cover your major essentials and your private pension to cover other spending.