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3 Reasons The FTSE 100 Could Beat An Annuity

On April 6, a massive change transformed the UK pension industry: retirees no longer have to buy annuities, and can choose to keep their pensions invested when they retire, drawing out their money as they choose.

I believe this is great news for private investors, and in this article, I’ll explain why a simple FTSE 100 tracker fund could be a better retirement income choice than an annuity.

1. FTSE vs annuity

To keep things simple, I’ve assumed that you will invest your pension fund in a FTSE 100 tracker in a SIPP, or spend the same amount on an annuity.

I’ve ignored the costs of a tracker, and have chosen the simplest, cheapest types of annuity, using illustrative quotes from the Money Advice Service website for a 65-year old man in good health.

Investment type

Rate of return

FTSE 100 10-year average total return

7.2%

Single fixed annuity

5.5%

Recommended annual drawdown from investment fund

4%

Single inflation-linked annuity

3.6%

Although the FTSE 100 has generated an average total return of more than 7% per year over the last decade, withdrawing this amount each year is unlikely to be sustainable.

The rule of thumb used by most investment advisers is that you can withdraw 4% of your fund’s original value each year, without eating into your capital.

On this basis, the income available from a FTSE 100 fund is similar to that available from an annuity. However, unlike with an annuity, you get to keep — and potentially spend — your pension fund.

2. Inheritance benefits

New tax rules introduced on 6 April 2015 mean that inheriting pensions is simpler and more tax efficient than before, whether you’ve already retired or not.

One of the big benefits of keeping your pension fund under your control is that your dependents may be able to inherit it when you die. With an annuity, the capital is kept by the annuity provider, in return for the security of income it provides while you’re alive.

3. You stay in control

Until now, the traditional approach to buying a pension has been that you take you 25% lump sum tax-free when you retire, and use the remainder of your pension fund to buy an annuity.

This rigid approach doesn’t necessarily suit modern lifestyles, however.

What if you plan to work part time for a few years before retiring fully, meaning that you will want to take a reduced income when you first retire? Perhaps you’d rather your lump sum remained invested, generating returns, until you actually want to spend it?

Ultimately, DIY pension investing won't suit everyone, but I believe it does have considerable potential.

One reason that the FTSE 100 is so well-suited for retirement investors is the size and quality of the companies which make up the index.

If you'd like to know more about some of the most attractive individual stocks in the index for pension investors, I'd encourage you to look at "5 Shares To Retire On", an exclusive Motley Fool wealth report.

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Roland Head has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.