18th May 2018
The Big Question When Approaching Retirement – Annuity vs Drawdown?
Is it better to purchase an annuity or take regular income via drawdown?
If you’re approaching retirement, you’d probably love to know the answer to that one, unfortunately it is not always an easy decision to make.
In April 2015, the tax rules were changed to give people greater access to their pensions in retirement. As a result of this, where previously for many people, it may have been deemed unsuitable to access their pension via drawdown, this is now an option.
The first thing to understand is that you can’t make a straightforward comparison between annuities and drawdown. This is because they are very different plans, working in completely different ways.
An annuity is actually a type of insurance. Specifically, it insures you against running out of income if you live longer than expected. Hence it pays you a guaranteed income for life – there is no central pot of money that can ‘run out’.
By contrast, drawdown involves an invested pot of money from which you make regular withdrawals of income.
How an Annuity Works
What is an annuity?
It pays you a guaranteed, taxable income for the rest of your life, giving you certainty throughout retirement.
What income will I get?
You will probably be shocked at how little income your pension fund generates. Annuity rates have fallen for 15 of the last 18 years, according to Moneyfacts, including a 11.5% drop in 2012
Annuity rates have been hit by low interest rates, falling gilt yields and rising life expectancy, which means insurers have to pay out income for longer.
Once you have bought an annuity, you can’t change it afterwards.
How do I get one?
Your pension provider will offer to sell you an annuity but you must shop around for the best deal you can get. This is known as “taking the open market option”, and can boost your income by as much as 20%.
If you have health problems, are overweight, or smoke, look for an “enhanced annuity”. This pays you a higher income because your life expectancy is shorter.
To add extra fuel to the argument there are different annuity options available to purchase:
- Level – Income remains the same throughout retirement
- Escalating – Income increases each year by a predetermined amount, e.g. RPI
- Joint Life – A percentage of Income is payable to a spouse on death, for the remainder of their life
- Enhanced – A higher income will be received based on a reduced life expectancy
- Investment-linked – Instead of providing a set amount, an investment-linked annuity provides income based on the performance of investments made by the provider.
- Guarantee – Provides an income for a minimum period of time upon death, e.g. 10 years
- Guaranteed Income for life
- No ongoing management or fees
- No flexibility once setup
- Death benefits restricted or even non existent depending on type of annuity purchased
- Generally seen as poor value for money
How an Income Drawdown Pension Works
What is income drawdown?
Income drawdown involves leaving your pension fund invested in a range of different assets, such as shares and bonds and drawing a regular income from it by cashing in some of those investments.
It is riskier than locking into an annuity because your money remains in funds that can go up and down, but may be more rewarding.
It allows you to benefit from any future stock market growth, and manage your cash flow better, as you only draw income when you need it
Who is it right for?
As a general rule, income drawdown works better for people with larger pension pots than people with less saved. The fees and charges are quite high and therefore a bigger pot makes it viable. Income drawdown also involves greater investment risk. If you have a larger pension pot, you are usually better placed to survive stock market volatility.
What income will I get?
That depends on the size of your pot and how well your pension performs. Your income could rise if stock markets do well, but fall if they do badly. You could even run out of money if you live longer than expected, something that can’t happen with a conventional annuity.
How do I sign up for it?
Income drawdown is complicated, and you will need help from a specialist pensions adviser. Don’t rush into any decision. It may have taken you 30 or 40 years to build your pension pot. It is worth spending time deciding what to do with it.
- Flexible use of pension fund
- Potentially higher sustainable income than available via an annuity
- Death benefits of pension value at time of death
- Investment risk
- No guaranteed income
- Pension could run out
- Higher costs & ongoing management require
This is not an easy decision to make, as both options provide valuable benefits in retirement and therefore careful consideration is required.
Whilst it could appear the flexibility available with Drawdown could seem attractive, there are risks involved with having this extra control.
An overview of your personal circumstances will provide much needed weight to this argument and assist you making the right decision. It is important to remember that the decision you make will impact the rest of your life and highlights the importance of seeking Independent Financial Advice before making any decisions.