When accessing your pension, should you opt for drawdown or an annuity? It’s 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.
So, let's analyse the key difference between a drawdown and an annuity below...
What is an annuity?
An annuity is a product that pays you a guaranteed income for life. It is a contract with the annuity provider (who will be an insurance company) to provide you with this income, in exchange for a lump sum at the start – which usually comes from your pension pot. 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.
Various different 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 (called an enhanced annuity).
Annuity income is taxed in the same way as ordinary income. Find out more about annuities.
What are the pros and cons of an annuity?
The advantages of an annuity are:
- It can never run out
- It maintains the same level of income (or increases)
- 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)
- Your income is inflexible (though you can choose an annuity that increases over time)
- An annuity can’t be inherited on your death (though you can choose one that continues to pay a reduced income to your spouse)
- Once you’ve bought an annuity, you can’t change your mind or trade it in
What is drawdown?
Drawdown is a way to take an income from a pension pot that stays invested in the stock market. You can draw out as much or as little as you like (provided the money is there), and these withdrawals are taxed as income. Any unspent funds can be passed on tax-free to your beneficiaries when you die. Find out more about drawdown.
What are the pros and cons of drawdown?
The advantages of drawdown are:
- You can increase (or decrease) your income whenever you like
- You can take larger lump sums if you wish
- Your beneficiaries can inherit any remaining funds tax-free
- You keep control of your pension pot (so you could change your mind and buy an annuity later)
The downsides of drawdown are:
- Your money can run out completely
- Your pension pot stays invested, so is vulnerable to stock market falls
- A drawdown scheme needs ongoing management (by you or your financial adviser)
- There is no guarantee you will get a better income than from an annuity
How do annuities compare with drawdown?
Here you can see the main features of these pension products rated side by side.
Ease of use
Enhanced if you have health problems?
The final point of comparison is the overall level of income you can expect from an annuity or from drawdown. Here, it is impossible to give a definite answer. During periods of stock market growth, you could expect higher income from drawdown than from an annuity. But when stock markets dip, they can shrink your drawdown pot by a large amount, reducing both your income and how long it might last. You need to be aware of this risk when considering drawdown as an option.
Should I choose an annuity or drawdown?
The question of whether drawdown or an annuity is better will depend on your own individual circumstances. Here are the main things that might influence your decision.
Reasons to choose an annuity
- You like the reassurance that comes from a guaranteed income for life
- You don’t want the burden of managing your pension
- You expect to live a long time
- You don’t 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
Can I combine an annuity with drawdown?
The question ‘Annuity or drawdown?’ is often presented as an either-or choice, but in practice there is no reason why you can’t have both. A combination of the two may provide you with the right balance of flexibility and security that you need.
There are two main ways in which you could combine drawdown with an annuity. The first is simply to divide your pension pot in two (perhaps equally, perhaps not) and buy an annuity with one portion, and leave the other invested in drawdown scheme.
The second way is to start off with all of your pot in drawdown, and buy an annuity later in retirement with all or some of the remaining pot. Why wait? The idea is that when you are older you should get a more generous annuity, and if you have some health issues by then, it may be more generous still.
You can find some good comparisons in this article, ‘What pension income will my £100,000 pot buy me?’
The surest way to make the right decision on how to access your pension is to speak first to an independent financial adviser, who will help you consider all the risks and benefits in light of your circumstances.
If you found this article useful, you might also find our article on the best drawdown pension providers informative, too.