Understanding your retirement income options is crucial for ensuring financial security in your retirement years. Oftentimes, pre-retirees feel confused about what options are available when converting their defined contribution pension plan into retirement income. There are currently two options available to receive retirement income – either through an annuity or utilizing the drawdown method. What you choose really comes down to personal circumstance and comfort level, and each has its pros and cons. An annuity is a financial product that provides a guaranteed income stream for a specified period, or for the rest of your life. When you purchase an annuity, you give a lump sum of money to an insurance company and, in return, they promise to pay you regular income payments. Purchasing an annuity is the traditional way to receive a retirement income, much the same as the way we remember our parents and grandparents receiving theirs when there were no other options available.
Advantages of Annuities
- Guaranteed income: annuities provide a steady income stream, which can be particularly beneficial for individuals seeking a predictable retirement income amount.
- Risk transfer: by purchasing an annuity, you transfer the risk of investment performance and longevity (i.e., outliving your savings) to the insurance company.
Disadvantages of Annuities
- Limited liquidity: Annuities are designed as long-term contracts and cannot be canceled or surrendered. This lack of liquidity can be a drawback if you need access to your funds unexpectedly or have urgent financial needs.
- High fees and expenses: Annuities can be associated with various fees and expenses, including sales charges, administrative fees, mortality and expense risk charges, and more. These costs can erode the returns and reduce the overall value of the annuity.
- Inflation risk: Fixed annuities offer a guaranteed income stream, but that income may not keep pace with inflation over time. This means the purchasing power of your annuity payments could decrease in the future.
- No beneficiary: Depending on the type of annuity selected, you may not have the option to elect a beneficiary. This means, should you pass away, the annuity payment will stop regardless of how recently or long ago it was purchased.
The alternative option to annuities is the drawdown method (a.k.a. pension drawdown), which is a more flexible way of accessing your retirement savings that is becoming increasingly popular for retirees. With drawdown, you keep your pension fund invested and withdraw money from it to provide your retirement income. This option allows you to take 25% of your entire defined contribution pension plan as a lumpsum at the age of sixty-five, and then drawdown the remainder based upon the Pension Commission’s specified retirement drawdown schedule.
Advantages of Drawdowns
- Flexibility: Drawdown provides greater flexibility compared to annuities. You can take up to the maximum allowed per year and select the frequency of the withdrawal, which allows retirees to tailor their retirement income based on their lifestyle, financial goals, and market conditions.
- Potential for higher income: With drawdown, your retirement savings remain invested, potentially allowing for growth over time. If your investments perform well, you may benefit from increased capital growth and higher returns, which could result in a higher retirement income compared to a fixed annuity payment.
- Inheritance: If you choose the drawdown method, any remaining pension savings can be passed on to your beneficiaries upon your death. This can provide an opportunity for intergenerational wealth transfer and may be more favorable than annuities.
- Investment control: Drawdown allows you to have control over how your retirement savings are invested. You can choose from a range of investment options based on your risk tolerance, investment objectives, and time horizon.
Disadvantages of Drawdowns
- Investment responsibility: With the drawdown method, the retiree makes the investment decisions, monitoring market conditions, and makes adjustments as needed. Therefore, if a retiree lacks investment expertise, or is not comfortable taking on this responsibility, it can put added pressure on a retiree.
- Volatility and sequence of returns risk: The performance of investments is subject to market volatility. If you experience negative investment returns, it can directly impact the following years’ future payment amounts.
At the end of the day, with any retirement income strategy, it’s crucial to weigh the pros and cons, carefully consider the potential advantages and disadvantages, and assess your own risk tolerance, financial knowledge, and preferences. Seeking professional financial advice can help you navigate these complexities and make informed decisions that align with your retirement goals.
Carla Seely is the Chief Operating Officer at Freisenbruch
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