What’s the difference between an annuity and drawdown?
Annuity and drawdown are the two main options for drawing money from your pension. When you purchase an annuity, you usually receive a set income for life. If you choose drawdown, you withdraw money from your pension pot, the remainder stays invested and can go up and down in value.
Which is better – annuity or drawdown?
It depends on your situation and many other factors. An annuity provides valuable certainty for the rest of your life, no matter how long you live, meaning there is less risk involved. Drawdown can see your pension pot increase if investments do well, but you also run the risk of it falling in value and you could run out of money before you die.
Below you can read about annuity and drawdown in more detail and view our comparison table.
An annuity is a financial product that you buy with your pension pot. It provides you with a fixed, regular income for the rest of your life. You can purchase protection against future inflation by having income increase by a fixed amount annually or perhaps an inflation-related measure like the Consumer Prices Index (CPI). You can also buy capital protection on early death, either by purchasing a fixed period of payments or protecting the original purchase price. The more certainty you want, the more expensive the annuity and therefore the lower the starting income.
Do not buy directly from your pension provider until you have reviewed rates in the open market. They can vary significantly and rarely will your existing pension provider offer the best rate.
As you cannot change your mind once you have purchased an annuity, you should shop around to ensure you make the right decision. A financial adviser can take you through the different products that are available and help you choose the right one.
Advantages of annuities:
- 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
Disadvantages of annuities:
- Less flexible - you can’t 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
Pension drawdown allows you to draw an income 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.
Advantages of drawdown:
- There is potential for your pension pot to grow more after you reach retirement age
- Generally considered more flexible than an annuity – you can change how much you withdraw and can purchase an annuity at a later date if desired
- Any proceeds on death are likely to be outside your estate for Inheritance Tax calculation purposes if you have signed a valid nomination of benefits
Disadvantages of drawdown:
- No guarantees – it is your responsibility to ensure your pension pot lasts for the rest of your life
- Investment risk – the value of your pension pot could go up or down depending on investment performance
Annuity vs drawdown
Once you have purchased an annuity, you will have bought a guaranteed income until you die.
You can draw an income from your pension pot, but it is up to you to ensure it lasts for the rest of your life. If you withdraw too much too soon, it could run out. Your income withdrawals can also be flexible and can be increased or reduced depending on how the fund is performing.
Opportunity for growth
When you choose to buy an annuity with your pension fund, you exchange the pension pot for the promise of a lifetime income and any investment value ceases.
As you are withdrawing income directly from your pension pot, there is the potential for your pension pot to grow, if investment returns are greater than the income you withdraw.
Level of risk
If you value certainty in the future, with a guaranteed income for the rest of your life, an annuity holds much lower levels of risk. It has statutory protection to 90% of its total value and inflation is the main threat, as income is payable for life.
The level of risk is determined by how you choose to invest the funds. Many different types of investment risk could apply depending on your choices. There are no guarantees and you could risk running out of money if you get it wrong.
Once you have purchased a lifetime annuity, the shape and amount of income generated is fixed. You can’t switch to another provider and there is no option to choose to go back to drawdown.
Fully flexible. You can change the value of your withdrawals to suit your current situation. If you opt for drawdown, you can still purchase an annuity later down the line.
There is no investment value to pass to loved ones on your death. However, at outset, you can buy a residual pension for your partner for the rest of their life.
Also, at outset, you can buy either, a guaranteed number of income payments so that on death any unpaid income is paid out. Alternatively, you can buy protection of the purchase price, which on death will pay the balance of the purchase price less the income paid.
On your death, any remaining funds in your pension pot not spent as income will be available to your beneficiaries. The tax position of payments is determined by your age at death. Up to age 75, they are generally payable tax-free to the successor. If you are over 75, they will be taxed at the marginal rate of the successor.
The value of the funds is unlikely to form a part of your estate for Inheritance Tax purposes. You must complete a nomination form to ensure trustees understand your wishes on death.
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.
This article is for information purposes only and is not suggesting a suitable investment strategy. Always seek financial advice before taking any action.