Annuity vs drawdown – which is best for me?
When accessing your pension, should you opt for drawdown or an annuity? It is the retirement dilemma of our age: do you play it safe with a steady income for life, or go for flexibility and take a higher risk in the hope of receiving more?
This side-by-side comparison of annuities and drawdown will familiarise you with the pros and cons of each, helping you to make the right choices when you access your pension.
What is an annuity?
An annuity gives you a guaranteed income for life in exchange for your pension fund. It might not be a big income, as rates are low, but you have the peace of mind that it will continue to pay out until you die.
The annuity income is not limited by a pot of money, so will continue paying out until you die. This means that if you live a long time, you may get back more than you paid for it.
However, you will be handing your cash over and losing the right to any growth from your fund or any flexibility and control over your income.
Various types of annuities are available. Some pay a fixed income, while others pay an income that increases over time (this can help fight inflation). You can also buy joint life annuities that cover both you and your spouse. Furthermore, if you have health problems you may be offered a more generous annuity.
Annuity income is taxed in the same way as ordinary income.
What are the pros and cons of an annuity?
The benefits of an annuity are:
- A guaranteed income for the rest of your life
- Financial certainty and security – the amount you receive regularly will be certain from outset.
- Option to protect your partner on death by purchasing a joint annuity so your partner carries on receiving a proportion of the payments after your death.
- Capital protection options are available.
- It is unaffected by changes in the stock market or economy.
- Once set up, it needs no managing.
The downsides of an annuity are:
- Your income is limited by the annuity rates on offer (which may not be generous)
- Less flexible – you cannot change the shape of your income or switch provider once you have purchased an annuity.
- Unlike drawdown, there is no investment value and therefore no pension pot to benefit from growth.
- As there is no pension pot there is no value to pass to your family or other beneficiaries unless you buy protection at outset and then payments will be determined by how long you live
What is drawdown?
Pension drawdown allows you to draw an income, regularly or in adhoc amounts, from your pension while the balance remains invested and able to grow. However, as with any investment, there is a risk that it could go down in value as well as up.
If you choose drawdown, then you give up future certainty for flexibility. You can vary your income over time to suit your circumstances. You can invest in a wide range of assets but if growth disappoints or you draw too much, or a combination of the two, it could result in you running out of money. There are no guarantees.
Any unspent funds can be passed on tax-free to your beneficiaries when you die.
What are the main benefits of pension drawdown?
The advantages of drawdown are:
- There is potential for your pension pot to continue to grow after you reach retirement age.
- Generally considered more flexible than an annuity – you can change how much you withdraw and can purchase an annuity later if desired.
- You can manage your tax liability (for example, you could adjust your income in a certain tax years to suit your situation)
- You can keep your options open by doing pension drawdown and then buying an annuity later.
- Any proceeds on death are likely to be outside your estate for Inheritance Tax calculation purposes.
- Your loved ones can inherit any remaining funds.
The downsides of drawdown are.
- You do not get a guaranteed annual income
- You could run out of money.
- There can be high pension drawdown charges.
- There is always risk in investing, and you might not want this in retirement.
- A drawdown scheme needs ongoing management (by you or your financial adviser)
Reasons to choose an annuity.
- You like the reassurance that comes from a guaranteed income for life.
- You do not want the burden of managing your pension.
- You expect to live a long time.
- You do not expect your spending needs to vary by much over time.
Reasons to choose drawdown.
- You are prepared to take some risk in return for a potentially higher income.
- You expect your spending needs to vary over time.
- You want access to larger sums in an emergency.
- You hope to leave your family a larger inheritance if you die prematurely.
Deciding how you use your pension pot when you reach retirement age can be complicated. The best choice for you depends on various factors.
A financial adviser can explain the different options to you, review your individual situation and help you make the right decision.