This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Tom McPhail, head of pensions research for Hargreaves Lansdown, explains the retirement income options for those with a pot of £100,000 or more.
It seems it has never been harder to extract a retirement income from your pension savings as cash and annuities pay record low levels of interest. For investors with pension pots of £100,000 or more there are alternatives, depending on how much risk you’re prepared to take on.
The great virtue of an annuity is that it provides certainty; once you’ve bought it, it guarantees to pay you a predictable income for the rest of your life and that of your spouse as well if you choose. The downside is that current low levels of interest rates - and particularly gilt yields - means that the return you get doesn’t look generous.
The top annuity rate for a 65 year old looking for a level income is 6.17%, which means you’ll need to live for over 16 years just to get your capital back; the life expectancy for a 65 year old man today is currently around 21 years and around 24 years for a woman. If you opt for an inflation-linked annuity then you get the security of never having to worry about inflation but you’ll have to put up with an annuity rate that starts off paying just £3,643 per £100,000 of pension fund.
At current rates of inflation you’ll almost certainly be better off with a level annuity unless you end up challenging Methuselah on the longevity front. If you want the annuity to continue to make payments to your spouse after your death then you have to select (and pay for) this option at the outset. A joint life annuity for the 65 year old mentioned above would pay only 5.643% if a spouse’s pension were built in at the outset.
So what of the alternatives?
You can use drawdown to withdraw an income from your pension fund. This gives you control over your income and your investments and would allow you to draw a higher level of income – currently up to £6,960 per £100,000. However there are obvious risks; your fund value can fall as well as rise and you could end up outliving your capital if you don’t manage your money diligently. Many investors found to their cost when Drawdown was first introduced in the mid/late 1990s that a stock market crash combined with high income withdrawals can do a lot of damage very quickly.
A big advantage is that you don’t have to worry about the death benefits; you draw your income from the fund and on your death your spouse can use whatever is left over to provide them with an income. In order to manage the income risk, our default recommendation would be for investors to draw the natural yield from their fund, which on a portfolio of equities would mean dividends of between 3% and 4% a year.
Neither of these solutions is perfect. I think for many people the best answer consists of a combination of the two. By splitting your capital and using some to buy a secure income from an annuity, with the balance being allocated to a drawdown plan, you can achieve a combination of security and flexibility, inflation proofing and death benefits.
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