Annuity or drawdown? Make a calculated choice

Some people want the security of an annuity – others, the flexibility of drawdown. But how can you decide which is better? Neil Adams of Drewberry Wealth shows you a simple way to compare these retirement options side by side.

Annuities have long been perceived as poor value, and pension freedom hasn’t helped. Since 2015, many comparing an annuity with income drawdown have been left with the assumption that annuities are a low-rate cousin to drawdown in the pension stakes.

So are annuities old hat?

The reality is, it’s not so simple. One way to ponder this puzzle is with the help of the new Annuity Calculator from Drewberry Wealth, which compares annuity rates from the UK’s leading providers. It reveals how much a range of the top providers will offer you in exchange for your pension pot.

Running a quick enquiry, we find that the best annuity for someone with a £200,000 pension pot is an index-linked income of £6,458.52 per year. This equates to an annuity factor of 3.23%. We’ve based this on a 65-year-old singleton who is in good health, a non-smoker and living in the same postcode as us (if you’re curious, that’s here!).

How long will your pension last?

The main benefit of an annuity is that it will provide a guaranteed income for the rest of your life, no matter how long that might be. As life expectancy rises – in 2017, Office for National Statistics projections give a 65-year-old man a further 21.6 years to live, to the age of almost 87 – this appears an attractive option.

Meanwhile the chief risk of pension drawdown is, to put it crudely, that your money will expire before you do. Fortunately (because we think of everything) we’ve also built a Drawdown Calculator to work out how long your pension will last in drawdown. Using this will help you see how advice can enable you to manage your money effectively in retirement and cut the risk of it running out too soon.

Annuity vs drawdown: How do the numbers stack up?

It’s tough to make direct comparisons between annuities and drawdown – that’s why there are two separate calculators. However, what the two tools do show is how well each option might serve you in retirement.

So what happens when we use our Drawdown Calculator to replicate the £6,458.52 index-linked annuity with a £200,000 drawdown pension pot? The monthly income from this pension pot is also inflation-proofed and we’ve based this on a 65-year-old male wanting to retire right away. We’ve also assumed a fairly pessimistic 2 per cent growth of the fund year-on-year.

In this calculation, your pension would run dry by the age of 96, leaving you with just the State Pension (if you qualify for that).

But that was just at 2 per cent growth. What if you had more luck? If your £200,000 drawdown pot grew by 6 per cent or more each year, then the power of compound interest means it would effectively never run out if you stuck rigidly to those same withdrawals – i.e. replicating the best annuity you could buy with the same initial pension pot. Even better, you would still have a significant sum – more than your initial investment – left in the pot to leave to your loved ones after your death.

Growth rate on £200,000 drawdown pot

Pension pot left at 87 if replicating a £6,458.52 annuity

Pension pot exhausted (age)

2%

£90,776.48

96

4%

£205,910.88

113

6%

£395,131.63

Never

So does this mean I could have a higher annual income?

These figures demonstrate that, given those same growth rates, you could take more in income from drawdown than you’d get from today’s record low annuity rates. In the next experiment, we replicate taking 50 per cent more in income from your drawdown fund than you’d receive from an annuity. And we find that, even at the 2 per cent growth rate, your pension would still last until you reached 85.

Growth rate on £200,000 drawdown pot

Pension pot left at 87 if replicating a £9,687.78 annuity

Pension pot exhausted (age)

2%

£0

85

4%

£68,128.91

91

6%

£219,584.51

109

Of course, with something as important as your retirement income, you shouldn’t take a decision based on a mere calculator. Other factors will come into play for you personally, which is why it’s important to consult a qualified pension adviser before coming to any conclusions.

Longevity risk

Even if your pension lasts until 85 with drawdown, however, there’s no guarantee this will be long enough. It’s still less than the life expectancy of a 65-year-old man and life expectancy doesn’t stand still. A 65-year-old man has a 7.2 per cent chance of reaching 100, while a woman of the same age has an 11.1% chance.

This means the average man aged 85 has another 6.6 years left to live. And those years could be very lean indeed if your pension pot ran out at 85 and you were still alive with an average life expectancy. A particular problem may arise if you were using your pension to pay for long-term care and suddenly no longer had the funding to do so.

That’s where an annuity offers more certainty. There’s no investment risk and the income you receive will be paid for the rest of your life, however long you live.

The price of that guarantee, though, is that your income may well be lower in retirement thanks to today’s poor annuity rates. What’s more, if you die before receiving back in annuity income everything you paid in, then a single annuity offers no continuation of payment and no return of the capital invested.

Start flexible, end up secure?

Here’s yet more food for thought. What if annuity rates rise in the future? That’s always a possibility as interest rates rise, while the uncertainty surrounding Brexit could push up government borrowing costs and thus the yield on gilts.

Fortunately, drawdown isn’t a one-way street. Even if you’ve started a drawdown scheme, you still have full flexibility to switch to an annuity later in life if you’re looking for a stable income. It may even be that in retirement your drawdown pension pot has grown to the point where you can secure a larger annuity. But as you can see, it’s complicated – and there are always unknowns and risks to factor in. Professional advice from an expert can help you make the right decision at every stage of your retirement journey.


Neil Adams is head of pension planning at Drewberry Wealth Management.