The Retirement Newsletter: Annuity vs. drawdown — what is the best way to use my retirement savings?
Issue Number: -27 — Will I go for an annuity or a drawdown?
Welcome
Welcome to issue -27, where I will look at annuities and drawdown and ask — what is the best way to use my retirement savings?
Money — Annuity vs. Drawdown
OK, I want to say that I am not a financial advisor. I am writing about what I have read over the years about money and preparing to retire. This is not financial advice.
I never thought I would be writing about annuities or drawdowns as a few years ago, when I looked at annuities, I convinced myself that they were not for me. That is, I would take the drawdown approach to use my savings in retirement.
Why? Well, at the time, a drawdown approach seemed to be the better option. But now?
So, what am I talking about? What are annuities? What is drawdown?
With your pension, you may have savings in the bank and investments outside your pension scheme. But you may also have extra savings in your pension scheme and receive a lump sum when you retire.
Any savings you have in your pension scheme in the UK are yours to do with what you want. But there is a catch. After you take 25% of the savings as a lump sum, the rest is taxable as you take it. Or at least that is my understanding.
The question is, what do you do with the money left after you have taken the 25%? How do you use it to finance your pension?
Well, there are two ways to use your savings in retirement — drawdown or an annuity. Although, depending on your pension scheme, you may not have the option of a drawdown but will have to buy an annuity.
If you don’t have to buy an annuity, you have a choice, but which is the best approach — drawdown or an annuity?
Drawdown
In drawdown, you keep your savings in the pension, bank or building society (or some other type of investment). You then withdraw a certain amount each year to fund your retirement. Over time, your balance reduces; if you have planned things right, your money runs out as you die.
If the money is in your pension scheme in the UK, then after taking the first 25%, you will be liable for tax on any drawdown from the pension if your income exceeds your annual personal tax allowance.
The advantage of drawdown is that you get to spend all your money (after you have paid tax on the drawdown) and have a reserve you can dip into for any unforeseen expenses.
The disadvantages are that you may run out of money before you die and have to manage your pension. And, if the money is coming from the pension, you have to pay tax.
Annuity
An annuity is a form of insurance you buy. And they cost a lot.
With an annuity, you get a set income for life. You buy the insurance, which pays you a set amount each month.
The advantage of an annuity is that you can’t run out of money. You cannot deplete your capital, as you have spent it to buy the product. And, you have a fixed income for life. You still pay tax on that income (subject to your tax allowance), but you have a set income.
The downsides are that annuities cost a lot, you may not recover your entire investment unless you live a long time, and once set up, it is a fixed income that is not easy to change.
Annuity or Drawdown? Which is it for me?
For years, I dismissed an annuity as a pension option as the rate of return, the income you get each month, was very low. And the reason it was low was because the rate is linked to something called “government bond (gilt) yields”., and those rates were low.
My understanding of “government bond (gilt) yields” is that the government uses them to finance public spending (I thought that was what our taxes did?). The government pays a fixed rate of return on these bonds. You buy a bond, and you get a fixed rate of return and your investment back when the bond matures. It is government borrowing, and it now costs the government more to borrow money.
The increased cost of government borrowing means that annuities have become more attractive over the last year or so as the return on “government bond (gilt) yields” has increased. And this makes them more attractive to people setting up their pensions. You get more income from an annuity than you did a year ago. I have seen some estimates that say you can get 20% more.
So, which way will I go? Annuity or drawdown?
I am still undecided. It is a big question, and I need to do more research. It also depends on the rate of return on an annuity when I’m in the market to buy one.
When I first looked at this a couple of years ago, my initial thought was to avoid an annuity because of the poor return. But now, things are different. Returns are up, so annuities need a second look.
Please note I am not a financial advisor. I am writing about what I have read over the years about money and preparing to retire. This is not financial advice.
Travel — Nostalgia Corner
Over a couple of years, I made two trips to Myanmar (Burma) and found it a wonderful and fascinating country. Here are some stories from my first trip:
On the road again - My first trip to Myanmar (Burma) — the start of my trip — first stop, Penang, Malaysia
Penang, Malaysia - I do like Penang, Malaysia — a brief visit to Penang
Finally, off to Myanmar, via Kuala Lumpur (KL) — never stay at the Plaza Premium Lounge
Welcome to Myanmar (Burma) — I have arrived in Myanmar (Burma)
Mandalay International Airport (MDL) and the drive to Mandalay — what a trip!
Newt week, exploring Mandalay, Myanmar.
Useful links
UK Government Website:
Next week
Next week, I start stressing that I only have six months until I retire.
Thanks
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Until next time,
Nick
PS, If you want to contribute something to the newsletter — a story, advice, anything — please get in touch.
Please note: I am not a financial advisor. My writing about money and financial matters is based on things I have read over the years about money and preparing to retire. IT IS NOT FINANCIAL ADVICE.
Wow. It's interesting learning the difference between the UK and US systems. We get Social Security sometime between 65-67, taxable. Private pensions are taxable, as is withdrawals from 401k and 403b savings plans. But we also have IRA accounts, not taxable until you withdraw funds (and you are mandated to start withdrawing those funds at age 72). Except for the Roth IRA. With the Roth, you pay tax when you deposit into the funds. THEN when you start withdrawing from the Roth, you don't pay taxes. Note: there's a yearly limit on how much you can put into a Roth.
The rationale for the regular IRA requirement is that you are in a lower tax bracket at that age, so the tax liability isn't as high.