Deciding how to take a retirement income is one of the biggest financial decisions you will ever have to make.
None of us know how long we’re going to live, so you need a strategy that ensures you don’t run out of money while living a comfortable lifestyle.
Attitude to risk and the impact of inflation are just two factors, and in the case of annuities once you’ve bought one, you’re locked in. These are decisions with real consequences and are just as important as those you make about how much you contribute to your pension and how you are invested.
In July we partnered with Oxford Economics to research the impact of our retirement income decisions and found that outcomes can differ significantly depending on the option taken. The analysis involved looking at comprehensive datasets outlining retirement spending patterns alongside people’s pension savings to give an overview of what people have and how they might spend it.
This article isn’t personal advice. Remember, you can usually access money in a pension from age 55 (rising to 57 in 2028). If you’re not sure an action is right for you, ask for advice.
Is the 4% rule a suitable retirement income strategy?
The 4% rule is one of the better-known approaches to drawing a sustainable retirement income.
The idea is that the retiree draws down 4% of their pension pot in the first year and then each subsequent year the amount taken is adjusted for inflation. It’s a strategy intended to deliver a solid stream of income while helping ensure they do not risk running out of money.
The possibility of balancing both these issues can bring real comfort. However, it does come with its challenges.
The analysis shows that while the 4% rule is designed to help prevent running out of money, it also risks people not taking enough income to maintain the standard of living they enjoyed before retiring. It’s a case of they could take enough money to survive but not live comfortably.
According to the analysis only 56.3% of households were estimated to be able to meet their preferred standard of living in retirement under the 4% rule. This involved looking at official data sets to assess how retiree spending patterns change over time.
You should also remember that the value of investments goes down as well as up, and depending on when you come to sell, you could get back less than you originally invested.
Alternative retirement income strategies
The research also looked at other strategies and found there were significant pros and cons of each.
For instance, a more aggressive income drawdown strategy whereby you would aim to draw down your pension by the age of 87 – in line with current life expectancy – would see 70.5% of households estimated to maintain their standard of living.
The major challenge with this is that while you might meet your standard of living, if you live longer than the average, you face running out of money and leaving you to rely only on the state pension for your remaining years.
Annuities are another popular option for retirement income.
Their key benefit is a guaranteed income for life, however long that might be. But there are many questions that need to be weighed up before deciding to buy one.
Once bought an annuity cannot be unwound, so if you make the wrong choice, you could have a long time to regret it.
Looking at someone choosing a level annuity at the age of 67 we see 72.5% of households initially being able to afford to maintain their lifestyle. This may seem high but the challenge with level annuities is that the income doesn’t rise over time. So, the income that seemed more than enough to begin with may leave you struggling later when inflation bites.
Purchasing an inflation-linked product sees the estimated number of households meeting their income needs run lower at 61.5%. This is because inflation linked annuities offer a lower starting income than a level product and this might mean that households initially struggle to meet their preferred standard of living.
However, over time this income will rise and offer a level of inflation protection that will protect your purchasing power.
Combining income drawdown and annuities
Deciding how to take a retirement income does not just have to be a straight decision between income drawdown and annuities. You can always combine them.
Hybrid strategies, where you start retirement in income drawdown and then transfer into an annuity later can be a good way of navigating the pros and cons. There are several ways of doing this. You could for instance annuitise part of your income as soon as you retire and keep the rest in drawdown or you could start in drawdown and then annuitise either in phases or completely at a later date.
The option we looked at in this research was to stay in drawdown until the age of 75 and then use an inflation linked annuity. You retain the flexibility that goes with income drawdown in the early part of retirement when spending needs are often higher. Then when you reach 75 you could consider an annuity using an inflation linked product. This would give you the benefit of a guaranteed income that rises over time and secures your purchasing power.
The decision to annuitise around 75 also means you’re likely to get a higher starting income than you would if you annuitised earlier. But remember, annuity rates can go up and down over time.
You may also qualify for an enhanced annuity, which could give your income a further boost. The analysis estimates that adopting a hybrid strategy including an inflation linked annuity will see just over 64% of households meeting their retirement income targets.
The results show the different trade-offs that need to be considered when assessing different retirement income options. While saving enough during your working life is key to affording the kind of lifestyle you want, it also shows the major impact different retirement decisions can have.
Being able to generate enough money to let you live comfortably for the long term is likely to involve making several decisions over the course of your retirement.
Retirees should also be wary about underspending for fear of running low of money later. This could lead to them potentially missing out on dream lifestyle goals, like travel, at a time when they’re fit enough to take advantage. It could also leave them with an inheritance tax headache if they have too much left in their pension in their later years. Balance is needed.
Financial advice will be key for many people in making sure the decisions they make are sufficiently robust and can change as and when needed. The government’s free Pension Wise service can also help, if you’re over 50 and need guidance about your retirement options.
Targeted support can play an important role. This approach lets providers make recommendations to customers based on what other people like them tend to do. It can have an enormous impact in helping understand the different options available to them and make more informed decisions.