Annuity or Pension Drawdown?

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The pension freedoms that came into force in April 2015 mean that anyone aged 55+ with a money purchase pension has a wider range of choices when it comes to turning a pension pot into an income.

Before pension freedom, most people were required to buy an annuity. Pension drawdown was only previously available to those with guaranteed, non-drawdown income of at least £12,000 a year. Now this restriction has been lifted, so anyone aged 55 or over can take advantage of pension drawdown to provide a retirement income.

  • Annuity
    An annuity offers a guaranteed pension income for life, so requiring pensioners to purchase them was one way to ensure retirees didn’t exhaust their retirement savings too early.
  • Pension Drawdown
    You pension pot remains invested and you take an income from it as and when you need it. There are no guarantees you will have enough income for the entirety of your retirement.

It is important to note that just because income drawdown is now available to anyone it doesn’t mean it’s automatically the right option for everyone. Whether or not drawdown is better than an annuity for you personally will depend entirely on your individual circumstances.

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What is an Annuity?

An annuity is a contract between you and a life insurance company. In exchange for your retirement savings, the insurance company promises to pay you a regular income until your death. No matter how long you live you will receive your pension even if the total payments are far greater than your original pension pot.

Annuities are irreversible. Once you’ve bought an annuity, you can’t alter the benefits you receive, get your money back, switch annuity providers to get a better rate or swap it for another type of annuity.

Different Types of Annuity

There are a number of different options when it comes to annuities that you may want to consider if you’re planning to use one to fund your retirement.

Single Life Annuity

A single life annuity is written just on your life and promises to pay you an income for life until you die. That’s fine if you have no dependants, or perhaps your partner has their own pension arrangement and isn’t reliant on you.

If, however, you need your pension payments to continue after your death to a spouse or dependent children, then you can either include a guarantee period or opt for a joint annuity.

Including a guarantee period

guarantee period is a set length of time your annuity will continue paying out after your death.

So if you buy an annuity with a 5 year guarantee period and die after only receiving your annuity for 1 year, it will continue to be paid to your selected beneficiary for a further 4 years.

However, if you outlive your annuity guarantee period, then your beneficiary won’t receive anything after your death. Also, a guarantee period won’t provide your spouse with an income for the rest of their life — only however long is left on the guarantee period.

Joint Life Annuity

joint annuity — sometimes known as a spouse’s pension or a widow’s pension — also provides you with an income for life. However, on your death, a joint life annuity then transfers to a named beneficiary for the rest of their life. This might be your spouse, partner or a dependent child (although a dependent child can only usually receive income from a deceased parent’s joint annuity until they’re a maximum age of 23).

When you buy a joint annuity, you have to decide the proportion of your annual income your beneficiary will receive, e.g. half or two-thirds.

The higher this sum, the lower the initial payment will be to you while you’re still alive. Initial annual benefits for joint life annuities will almost always be lower than for single annuities, because insurers anticipate having to pay an income for longer.

Enhanced Annuities

If you’re a smoker and / or retiring in poor health, then you might qualify for an enhanced annuityThese are also known as impaired life annuities and offer a higher annual retirement income than standard annuities to those who are ill because your ill health means you’ll likely draw on an annuity for a shorter time than a healthier person.

Should I Get a Level or Index-Linked Annuity?

fixed annuity — also known as a level annuity or flat-rate annuity — pays you a set annual amount from the start of the contract until your death. However, this runs the danger that the purchasing power of your annuity income will be eroded over time by the effects of inflation.

To avoid this, you can choose to index-link your annual benefit by purchasing an escalating annuity. With these, the payment rises each year, either in line with inflation or by another fixed percentage agreed with your annuity provider.

The trade-off is that, because your annuity payments will rise over time, the amount you usually get to start off with is smaller than for a fixed annuity.

Should I Buy an Annuity?

Rising longevity means that annuity companies have cut the rates on offer to compensate for the fact that pensioners are living longer and therefore drawing on annuity income for an extended period.

Poor investment returns due to the rocky economic climate since the financial crisis, as well as various other economic turbulence, have hampered annuity firms’ investment returns as well.

This comes at a time where the new pension freedoms mean no one is required to buy an annuity anymore, resulting in fewer people taking an annuity as the ‘default’ option.

This said, although annuities aren’t offering great rates currently, it’s worth reiterating that they will provide you with a guaranteed, lifelong income that will never run out.

Advantages and Disadvantages of Annuities

As with all financial products, annuities come with pros and cons. An annuity may not necessarily be right for your circumstances, so it’s important to weigh these up and ensure you’re making the best decision for your retirement.

If you’re at all unsure, it’s best to consult a pensions expert.

Advantages of Annuities

  • An annuity won’t run out
    No matter how long you live, an annuity won’t ever stop paying you a pension
  • Your income from an annuity is guaranteed
    No matter how long you live or how the annuity provider’s investments perform, your income is guaranteed for life
  • Annuities can reflect poor health
    An enhanced annuity can help tailor your pension to your needs by paying a higher annual sum to compensate for the fact that the annuity provider will likely be paying out for a shorter time due to poor health
  • An annuity can provide a pension for dependents
    Joint annuities can provide a spouse’s pension if your partner doesn’t have much in the way of a pension of their own
  • No investment risk
    While the value of investments can fall as well as rise, you’re not exposed to investment risk with an annuity
  • Protect your income from inflation
    Opt for an index-linked annuity to ensure your income rises each year in line with inflation and your pension isn’t eroded in ‘real’ terms.

Disadvantages of Annuities

  • No opportunity for investment growth
    With drawdown, your pension remains invested in retirement, which isn’t the case with an annuity; as such, an annuity offers no chance of investment growth on your retirement savings
  • Annuities are irreversible
    You can’t change your mind with an annuity once you’ve purchased it and you have to decide everything at the outset
  • Annuities can’t be changed if your circumstances change
    Should the worst happen and you discover that you’re terminally ill after buying an annuity, there’s no way to get access to your original capital if you wanted to fulfil a ‘bucket list’, for example.
  • Inheritance rules are tricky
    Unless it’s a joint annuity, which tend to come at the cost of a lower initial income, it’s difficult if not impossible to pass an annuity on to your loved ones after your death
  • You could get back less than you paid in
    If you die before receiving back in income everything you paid in from your pension pot, there’s little opportunity for redress (unless you’ve bought a capital protected annuity)
  • Annuity rates are currently low
    With annuity rates so low currently, annuity pension income isn’t fantastic in the current economic environment.

What is Flexi-Access Drawdown?

Pension drawdown — known variously as flexi-access drawdown, income drawdown or flexible drawdown — involves leaving your pension invested and drawing on that fund for an income as and when required. You can create your own schedule of income and lump sum payments.

The downside of drawdown is that your pension pot is finite, which means that it could run out in retirement. There’s no guarantee of income as there is with an annuity.

How Does Income Drawdown Work?

You can gain access to most defined contribution pension pots from the age of 55 onwards. To move your pension into income drawdown, you shift the cash from your pension pot and into a drawdown investment fund or funds of your choosing.

From this pot, you then draw an income from the underlying investments, which may include taking lump sums as required.

You’ll have to manage your pot carefully to ensure you don’t take out too much money and leave yourself without any retirement savings in old age.

Is Drawdown Right for Me?

You might be more suited to drawdown than an annuity if you’re keen for investment growth in retirement, something an annuity simply won’t provide.

Drawdown also offers more flexibility than an annuity, which is another factor that might attract people to drawdown compared to an annuity.

However, drawdown may not be suitable for those with smaller pension pots or those who want a guaranteed income for the rest of their life.

Whether or not pension drawdown is right for you will depend on your circumstances — it’s worth discussing this with a qualified pension adviser to ensure you’re opting for the best option to secure your retirement income.

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Advantages and Disadvantages of Pension Drawdown

Drawdown is a more flexible way of taking your pension than an annuity. It’s now available to everyone, regardless of the size of your pension pot. However, that doesn’t mean it’s the right option for all those approaching retirement.

Advantages of Income Drawdown

  • No restrictions on what or when you can withdraw from your pension
    Although you’ll always have to consider the tax implications, the cash it there to use as and when you see fit
  • Room for investment growth
    As your fund remains invested, there’s the potential for investment growth in your later years
  • Easier to leave a pension to loved ones
    Any funds remaining in your pension pot when you die can be passed on to your beneficiaries. If you die before the age of 75, this will be tax-free; if you’re 75+ when you die, your beneficiaries will have to pay income tax on the fund at their highest marginal rate.
  • Availability of other retirement options
    If you decide to opt for pension drawdown, you can change your mind and buy an annuity with your remaining pension pot at your later date
  • Income can be variable
    You can adapt your income to meet your changing circumstances, increasing it when you need more income or reducing it when you need to, potentially with a view to reducing your tax bill.

Disadvantages of Flexible Drawdown

  • Your pension pot is finite
    The biggest risk when it comes to drawdown is that your money might run out if you overspend, your investments underperform, you live longer than expected (or all of the above). We’ve built a Pension Drawdown Calculator to help you understand what might be a sustainable income
  • Withdrawals are taxable at your highest marginal rate
    You pay income tax on cash you take out of your pension pot via drawdown just as you do on all other income, so taking a big lump sum could bump you up a tax bracket and land you with a hefty bill from HMRC
  • You’ll face investment risk in retirement
    The value of investments can fall as well as rise, meaning you could get back less than you invested.
  • Be wary of withdrawal fees
    You may have to pay withdrawal fees each time you make a withdrawal from your pension pot
  • Fees are likely higher than for annuities
    As there’s an element of ongoing management when it comes to drawdown, rather than a one-off purchase as with an annuity, you’ll likely face higher charges with drawdown.

Annuities or Drawdown: Which is Best?

Whether you should opt for an annuity or drawdown to fund your retirement very much depends on your individual needs and circumstances.

Many people prefer to have the security of a guaranteed income for life, which an annuity provides. Then they know that their pension will never run out, no matter how long they live.

Other people will be keen for investment growth in retirement and want it to be easier to pass down their pension pot to their loved ones. For such people, drawdown could well be a better option.

Those with larger pension pots may be more suited to drawdown than an annuity because there’s less risk of the pension pot running out before they die. This said, all pension pots are at risk of running dry if you take too much, too soon or your chosen investments underperform.

Your Financial Plan – Build A Better Future

A good financial plan can help you make the right decisions when it comes to your finances. Make the right decisions today to build a more prosperous future.

Good financial planning with clear goals can increase your retirement income by as much as 53%. Old Mutual Redefining Retirement Survey

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