In the mix: annuities, bonds and SIPPs

Let's change the numbers for once. Anna has a SIPP of £133,333. Now she is 60 she would like to draw a pension from it. She is a cautious investor (the C portfolio is 75% boring, 25% bouncy; in her case index linked gilts and global equities).

She can't decide between keeping it invested and drawing an income, or buying an annuity. Access or stability? That is the choice she is faced with. So she goes for a bit of both.

She figures that her investing in index-linked gilts is not that much different from buying an annuity. So if 75% of her SIPP was going to be in bonds, why not just buy an annuity anyway? Sure she says goodbye to the money, but it will give her that certainty she is looking for.

So Anna takes her 25% tax free cash - and pays £100 000 for an annuity. But she is not done yet. She is still earning and saving (and has £33,333 in cash in the bank). So she starts another SIPP and starts paying into that. And, thanks to her regular annuity income, she thinks: 'maybe I am not such a cautious investor any more'.

The moral of this story is that once you reach pensionable age (55) you have the option of swopping the 'bonds' side of your portfolio for an annuity.

Remember a 'pure' annuity actually returns all your money to you over your expected lifetime, meanwhile investing it in gilts. Hence the low-return on your 'investment'. ( A real world annuity does much the same, except it keeps back 10-15% for profits/expenses and holds corporate bonds too).

So annuities have two big drawbacks:

• you lose money if you die early
• your savings are invested at low yields (gilts), possibly for decades

but if your savings were invested in gilts anyway, one of the drawbacks is eliminated.

Anna takes one more decision - she decides to go for the maximum, flat rate annuity. (£475 a month, versus £260 for RPI linked).This 'front loads' her payments from the insurance company and it will help her save still more into her SIPP. And with that income secured she feels she can be a bit more adventurous in her new portfolio.

Vanilla smoothie

Despite the vanilla approach - keeping things as simple as possible - choosing a withdrawal rate from your pension pot is tricky. You can see why most people don't bother trying, and just opt for a standard annuity. It's fixed, it's guaranteed, it will last as long as you live.

But here's ways to smooth your usp (aka unsecured pension, or income drawdown).

1 Invest in government gilts in your SIPP (self-invested pension scheme) or even index-linked gilts. This is a good choice for someone who wants a secure and stable return, but is not ready to lose control of their savings by handing them over to an insurance company for an annuity. This is an option that doesn't get much publicity. The returns are likely to be unspectacular - as are the fees to advisors.

2 Smooth your return by taking the average of last year's payout, and 4% of this years fund total. So if your fund is £115,000 - and last years pay out was £4000- you only pay yourself £4300 and not the £4600 that the basic 4% rule would have given you.

And because last years payout was calculated the same way this simple rule weights your return by your long-run return. (The weighting for the current year is 1/2, and for the preceding years 1/4, 1/8, 1/16 etc).

3 Increase payout with age: 4% in your fifties, 5% in your sixties, 6% in your seventies.

By the time you get to your mid sixties, this is quite conservative (especially for men - their life expectancy is several years shorter than for women). But it might feel scary - your pension pot might be going down. This is not just living on income - it's eating into capital too

So is a SIPP preferable to an annuity? It comes down to personal choice - but one big factor is that you can always change your mind and buy an annuity - but you can't change it back again.

Three kinds of 4%

Nowadays you don't have to buy an annuity with your pension pot - you can invest it and draw an income instead [often known as income drawdown]. This pot can still be used to buy an an annuity later [up to age 75] if you want.

So how much can you safely withdraw each year? Well the answer depends on your life expectancy and your future investment returns. Both are very uncertain, so much attention has been given to finding the 'safe withdrawal rate' even allowing for poor stock market returns, and increased longevity.

The standard answer is around 4%.

But there are three kinds of 4% withdrawal on - say - a $100,000 pot. (We are talking dollars here because its in the USA that this has been studied most).

1 Take $4000 a year index linked. So it goes up with inflation.

2 Take $4000 every year - flat rate.

3 Take out 4% of your pot whatever its size.

Option 1 is the toughest to maintain, option 2 is usually what is meant by the 4% rule, option 3 is the 'safest'. Where safety means you will never run out of money (although you might run short of money).

The vanilla pensioner goes for option 3, despite its drawbacks which are:

• your income will bounce up and down with the value of your fund; and
• it doesn't allow for the fact that as you get older, you should be able to withdraw a higher percentage from your fund

We will look at ways to fix this, without straying too far from the underlying philosophy: the size of the pension you can take depends on the amount of money you have - not on the amount of money you used to have.

And that is the serious drawback of options 1 and 2 - blithely taking $4000 a year even though your fund may have dropped to $60 000.