How to get the best income from your pension pot

Pensions are complicated. But few would argue that saving for retirement isn't a good thing to do. In a recent issue of MoneyWeek magazine, we compared pensions and individual savings accounts (Isas) as ways of saving for retirement.

But what about retirement income? How do you turn your pension pot into the best income stream for you?

Not so long ago, one of the main arguments against having a pension was that you had to buy an annuity with at least 75% of your fund (25% can be taken as a tax-free lump sum). Annuities are seen by many as inflexible dinosaurs in need of change.

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The good news is that annuities are no longer compulsory. However, while there are other ways to generate an income from your investment fund, remember that none of themare perfect.

In fact, there are good reasons to suggest that buying an annuity should still form at least part of your retirement income plan.

What are annuities?

When you buy an annuity, you hand over a lump sum of cash (usually your pension fund) to an insurance company in return for a regular, guaranteed income for the rest of your life.

This income is taxable if it exceeds your personal allowance. But there are different kinds of annuities. You need to understand these when buying them.

The most basic annuity is a level annuity. Here you get a fixed income for the rest of your life. It will not change if prices go up. So in an inflationary world, the purchasing power of this type of annuity will go down every year.

For example, if inflation averages 4% per year, the purchasing power of your annuity income will halve in 18 years. If you die, the income paid from this type of annuity usually stops.

If you are worried about rising prices, you could buy an increasing annuity. Here, the amount of income you receive can increase in line with inflation each year or by a set percentage amount instead.

If you are worried about your insurance company keeping a large chunk of your pension fund should you die after only a few years of retirement, you could buy a guaranteed annuity.

For example, if you bought a five-year guarantee and you died after two years, your nominated beneficiary (say your husband or wife) would receive annuity income for another three years.

Another option is a joint-life annuity. This is where your partner can receive some or all of your pension income if you die before them.

If you want to take a bit more risk, you could go for an investment-linked annuity. Here you start with an initial level of income while your fund is invested in an insurance company's with-profits-fund. If the fund makes a profit, your income goes up. If it loses money, your income goes down.

What do you get for your money?

Annuity rates have tumbled in recent years. There are two main reasons for this.

Firstly, people are living longer. This means that insurance companies have to keep paying incomes for longer. Secondly, falling interest rates make it harder to generate a source of funds to pay annuity income.

At the moment, a 65-year-old male with a £100,000 pension pot can expect an annual income of just over £6,000 if he buys a single life, level annuity. Other examples are shown in the table below:

Source: Financial Times, Hargreaves Lansdown

As you can see, the more conditions you attach to the annuity (such as inflation protection, or death benefits) the less initial income you receive.

However, you may get a higher income if you are a smoker or have an illness. Here the annuity provider is betting that you won't live as long so it can pay you more. This is often known as an enhanced annuity or impaired life annuity.

So should you buy an annuity?

If you are retiring just now, low annuity rates probably make you wince. However, that doesn't mean you should ignore them. They still have some good things going for them.

Once you have bought your annuity, the income you receive is effectively free from investment risk. That has been transferred to your provider. There is also little danger of running out of money as your provider has to pay you for as long as you live.

What happens if your annuity provider goes bust? You get compensation from the Financial Services Compensation Scheme (FSCS) as an annuity is classified as long-term assurance. This means that the level of protection is unlimited and is calculated as 90% of the claim.

If you don't want to buy an annuity now because of low rates, there are a number of strategies you can turn to. One option is known as phased retirement. This is where you set up a series of annuities and drawdowns with 25% tax-free lump sums. You will get a lower starting income, but if you think annuity rates are going to increase it might be worth considering.

Another possible option is fixed-term annuities. Here you set up an annuity for a fixed period, sayfive orten years. You get paid an income for the fixed term but at the end of the period, you have a guaranteed pot of money to reinvest again. As with phased retirement, your income will be lower than from a standard annuity.

When you take everything into consideration, it seems that annuities are quite a good way of providing a retirement income. They are becoming more flexible and they have little or no investment risk although inflation-proofing is not easy.

You are also unlikely to run out of money. Therefore it looks like a good idea to consider annuities for at least some of your retirement income.

Is income drawdown a better strategy?

Of course, you don't have to buy an annuity at all. Instead you can leave your pension fund invested and take a regular income from it.

The maximum amount you can take each year is determined by your age and government actuary department rates (GAD). These rates are based on 15-year government bond yields.

At the moment, the GAD rate is 2.75%. This means that a 65-year-old male with a £100,000 pension fund can take an annual income of £5,800 per year. For the under-75s, the amount of income you can take is reviewed every three years. After 75, the amount is reviewed every year.

At first glance, income drawdown seems quite appealing. But is it really? Yes, you get to remain in control of your pension fund, but you can't take any more income than you could with an annuity.

The big risk with income drawdown is that your fund can remain exposed to the investment markets (unless you hold it all in cash). This means your fund could go down in value and limit the amount of income you can take from it. You don't have this risk with an annuity.

Another risk is that you could run out of money. You could live longer than your fund's ability to pay income. Again, with annuities you don't have this risk.

One benefit of income drawdown is that you can leave some of your fund to your relatives. After your death the beneficiary could take a lump sum after it has been taxed at 55%.

Alternatively, they could continue with income drawdown. Or they could use the fund to buy an annuity. On this point, income drawdown is superior to most annuity products.

Those with bigger pension funds might want to consider flexible drawdown. This removes the cap on how much income you can take from your fund each year. But to use this scheme, you need to have a secure income of at least £20,000 a year. This might come from a company pension scheme or an annuity.

So, what you could do is buy an annuity to cover your main expenses and then take an amount from your pension fund for other purposes. You still need some luck (hopefully your fund won't suffer large falls in value) and try not to run out of money. This could be a sensible strategy, but again the stability provided by an annuity income is a key attraction here.

What if I use Isas to save for my retirement?

Isas are much simpler than pensions. But you have to be disciplined to make them work as a retirement plan. (Unlike pension funds, you are free to spend all of your Isa money before retirement)

There is nothing to stop you buying an annuity with your Isa. However this would defeat the object of having an Isa in the first place. Annuity income is taxable whereas income and capital taken from an Isa is not.

When we compared pensions and Isas, we found that with the same contributions and investment returns, both were capable of providing a similar amount of retirement income. This was because the benefit of tax relief on pension contributions roughly equalled the effect of tax-free income taken from Isas.

The key to getting the same amount of income from an Isa is the rate of return on your investments. Can you get 5.8%-6% per year that would give you the same amount as fromincome drawdown or an annuity?

The answer to this question is yes, but you have to take risks that you don't have to with annuities.

You could be a great investor who can easily get more than 6% a year from their fund. But most of us are not good enough to do this consistently without big risks. You could alternatively just draw capital from your Isa every year. But as with income drawdown, you have to be careful not to outlive your fund.

One option is to buy a high-yield bond fund. There are lots of these available with yields of 7-9%. That's because they buy risky bonds of companies such as banks. However, the risk to your capital is quite high too. The ones I looked at were all trading at levels a lot lower than their launch prices.

Another alternative is to put together a portfolio of blue-chip, high dividend paying shares that are capable of growing their payouts then sit back and let the money roll in (hopefully).

This sums up the strategy advocated by my colleague Stephen Bland in The Dividend Letter newsletter. He has built a number of high-yield portfolios (you can find out more aboutThe Dividend Letter here).

You could throw in some decent higher-yielding preference shares and you might get the same income as an annuity. While this strategy has risks, if the dividends start to grow then you could end up with a much better income than an annuity over the long term.

But what is clear again is that annuities have their benefits and can be better products than most people initially think.