The subject of pensions can be quite confusing. We all know what a pension is and how important your pension fund will one day likely be. But what about terms like “annuity” and “drawdown”? One term is about receiving a fixed income for life, while the other is about withdrawing an amount of money from your pension pot while the remainder stays invested for growth. But which is best?
| What is one advantage of an annuity? | It guarantees an income for life |
| What is an advantage of a pension drawdown? | Access pension fund and withdrawal of money when needed |
| Can an annuity and pension drawdown be changed after purchase? | An annuity can’t be changed after purchase, while income amount changes can occur with a pension drawdown |
| Does investment risk affect annuity and drawdown? | There is no investment risk with an annuity, but a pension drawdown carries investment risk |
In this Moneyfarm blog, we explore the annuity vs drawdown debate. We’ll look at the pros and cons of each, and hopefully, by the end of the discussion, we will have helped you to make a more informed decision as to which of the two options will be more appropriate for you.
Pension drawdown explained
What is pension drawdown? If you choose drawdown, you’re selecting a system that allows you to access your pension savings by drawing down or withdrawing an amount from your pension pot, leaving the remaining funds still invested and able to continue growing. Having said that, as with all investments, there is a risk. The value of your pension pot can fall as well as rise.
Annuity explained
The alternative to pension drawdown is to purchase an annuity. What is an annuity? If you choose to buy an annuity with your pension fund, you will be setting up a guaranteed retirement income for the rest of your life.
Pension drawdown vs annuity – which should you choose?
The decision regarding annuity vs drawdown is personal, and it varies for each individual according to their financial circumstances and attitude towards risk.
The pros and cons of annuities
| The Pros of an Annuity | The Cons of an Annuity |
| You get a guaranteed regular income for the rest of your life. | Less flexibility. Once purchased, an annuity cannot be cancelled, and the income is fixed. |
| Because annuity income is a financial certainty, it reduces stress and uncertainty. | Once an annuity is purchased, your pension pot is no longer subject to any growth. |
| The option to protect your partner if you die by purchasing a joint annuity. | There is nothing to pass on when you die unless you opt for protection at the outset. |
The pros and cons of drawdown
There is an interesting blog on the Moneyfarm website that lays out the pros and cons of pension drawdown, and it’s well worth reading. The main points are laid out in the table below.
| The Pros of Drawdown | The Cons of Drawdown |
| The money remaining in your pension pot has the opportunity to grow. | There is no guarantee you will not run out of money. |
| Greater flexibility | The value of funds left in your pension pot could fall. |
| Inheritance funds outside of your estate valuation if a benefit nomination was signed. | Drawdown requires ongoing management from you or your financial advisor. |
How to choose between annuities and drawdown
Is pension drawdown better than an annuity is a question people ask, and you will need an annuity v drawdown calculator to help you decide.
Annuity rates decide what the guaranteed income will be. They depend on things like your health, how long you live (your life expectancy), and interest rates. The longer you’re expected to live, the lower the income and vice versa. The calculation also depends on interest rates. The lower the interest rate is, the lower the annuity rate. When pension pots are used to buy annuities, they are usually invested in government bonds by the annuity provider.
The key factors to consider when evaluating annuities and drawdown
One of the key factors to take into account in the ‘is drawdown better than annuity’ debate is that in recent months annuity rates have been hit not only by low interest rates but falling treasury bond yields too.
Add to that the fact that people are living longer, so the income they provide is, therefore, over a longer period, and it all comes together in a perfect storm that results in lower rates. If you then consider that those lower rates are facing the highest inflation we’ve seen in decades, it means that fixed annuity income can lose considerable value in real terms.
High inflation cannot be ignored when it comes to the flexible drawdown vs annuity argument. The state pension is adjusted so it doesn’t lose value in real terms by the triple lock mechanism.
Similarly, private pensions or a SIPP (if you invest in a SIPP – which is a good option in terms of self-employed pension contributions) all benefit from having the freedom of interest rates. Yes, interest rates can fall too, but they can be designed to provide a hedge against inflation. Also, the way compound interest is applied means that funds can grow considerably in value. This is one of the key factors in the fixed-term annuity vs drawdown comparison.
The tax implications of annuities and drawdown
The tax implications regarding income drawdown vs annuity are the same. Whichever you choose, you can take 25% of your pension pot tax-free prior to set up. After that, any money from your pension you take as part of income drawdown or annuity income will count towards your income tax threshold. Anything above the threshold will be subject to tax according to which band you fall into.
With an annuity, you do not have to worry about capital gains tax, but with income drawdown, anything left in the pot can still grow and could therefore trigger capital gains tax. The pension lifetime allowance is due to be abolished as per the recent Spring Budget announcement. However, the Labour party has said they will reverse this decision if they are voted into power, so it remains to be seen.
When is a good time to buy an annuity?
If you are asking yourself when to buy an annuity, a good time could be when you retire completely. The steady income stream from your employment will stop, but you will still have to pay essential bills. Purchasing an annuity with part or all of the funds in your pension pot will help you to cover this.
Annuity vs drawdown – examples
According to The Times Money Mentor, if at the age of 65 you have a pension pot of £100,000, the possibilities regarding annuity vs drawdown could be as follows.
Annuity example
- You buy an annuity with your £100K pension pot,
- The best annuity annual income might be £4,970
- With inflation protection, the early-stage annual income might be £3,273
- With no inflation protection, early income is higher but is fixed and will lose value in real terms due to inflation
Drawdown example
- If you follow the 4% rule, you take a 4% income in the first year, increasing each year by the rate of inflation.
- In year 1, income is £4,000 per annum.
- 20 years later, assuming 1% per annum annual inflation, income would be just over £4,500.
- Assuming 5% growth and 0.45% charges capped at £200 per annum, your pot might have grown to just over £112,000.
- If you take £6,800 in year 1
- Income in year 20 would be £8,215, but your pension pot would be completely depleted.
Closing thoughts
Asking yourself how much do I need for retirement before the day arrives is likely to be one of the last elements of your retirement planning. The earlier you plan for this, the better. But don’t forget that in the annuity versus drawdown debate, once you set up an annuity, that’s it. You can’t change it, so tread carefully.
One last thing to remember is annuity vs drawdown is not an either/or decision. There is the drawdown vs annuity vs cash approach, whereby you can take your 25% tax-free lump sum and use the rest to buy an annuity and convert the balance to a drawdown. Of course, your pot would have to be big enough.
FAQ
Which is right for me, annuity or pension drawdown?
It all depends on your financial situation and retirement goals. An annuity guarantees a steady income stream but may have lower flexibility, while a pension drawdown allows more control over the funds but carries investment risks. So, choose the option that will fit your retirement needs.
Can annuity and pension drawdown be combined?
Yes, combining an annuity and a pension drawdown is possible to create a retirement income plan that provides both guaranteed income and flexibility.
Should I seek professional advice before choosing between annuity and pension drawdown?
Please seek professional financial advice before deciding between an annuity and a pension drawdown. Weigh the pros and cons of each option with a financial advisor before proceeding, as each option has unique advantages and risks that depend on an individual’s financial situation and retirement goals.
*As with all investing, financial instruments involve inherent risks, including loss of capital, market fluctuations and liquidity risk. Past performance is no guarantee of future results. It is important to consider your risk tolerance and investment objectives before proceeding.
