Annuities vs Drawdown – The Big Fight!
Updated 23 January 2018
In the blue corner, the long-reigning champion of retirement planning: the annuity! In the red corner, the challenger for the pension freedom crown: drawdown! But which is better? There’s only one way to find out.
Some people enjoy a flutter now and then; others really aren’t keen on betting. But all of us will one day have to place a very big wager, staking most of our life savings in the hope of winning a comfortable retirement. For most of us it will come down to a choice between two contenders: the annuity (an insurance product which will pay you a guaranteed income) and drawdown (a scheme for keeping your pension pot invested, so you live off the income). Which one would you put your money on?
Here’s how the combatants square up.
Which can give you a bigger income in retirement? If you’re talking ‘potentially’, then drawdown wins this round easily. Assuming the stock markets perform strongly and your fund is well invested, then a drawdown scheme could deliver much more income in a given year.
By contrast, a standard annuity will deliver an unchanging level of income, and since annuity rates have been in decline lately, this income may be distinctly modest. So annuities in their old age are no match for drawdown? Well, the fight’s not over yet…
Which will stand up the longest? There’s no contest here – it’s the annuity. A lifetime annuity is just that: it will pay out until you die (and maybe for longer, if your spouse is covered too). This is because an annuity is not a fixed pot of money but a contract between you and an insurer; even if you lived to be 120, it would still have to pay up.
But with a drawdown scheme you really have to pace yourself. Your fund is still finite, and if your pace of withdrawal is much higher than the rate of growth, it could end up being exhausted. If you live to be very old, you may find your drawdown scheme out for the count.
Ducking and diving
Or, flexibility. How versatile is each option? Drawdown has the advantage here: you can draw as little or as much as you like each year (although there may be upper limits, depending on the scheme), so you can raise your level of income according to your needs. This can be very useful: most people have some high-spending years followed by quieter periods.
An annuity is much less convenient – but not completely inflexible. It’s possible to buy a temporary annuity that will last exactly as long as you specify (perhaps to enhance your income in the early years) or an escalating annuity, where the amount rises each year to combat inflation – though this is more expensive. Combinations of annuities can produce very good outcomes, if you take good financial advice. This is a close round.
Big right hand
Each of our contenders has a secret weapon. With annuities, this is the possibility of an enhanced annuity if you have health problems – essentially, you may receive more money every year because your life expectancy is not so high. Certain lifestyle factors (such as being a long-term smoker) can also make you eligible.
Drawdown offers no such health-related advantages. But thanks to pension freedom, it does enable you to pass on any unspent funds to your beneficiaries when you die, free of inheritance tax. It’s worth pointing out, however, that annuity benefits can also be passed on to beneficiaries tax-free if you have selected value protection (which allows you to pass on a lump sum). Call this round a draw.
So much for the strengths – what about the weaknesses? Annuities have two big downsides. The first is that current rates are low, so it is expensive to buy one that can deliver you a comfortable income. However, shopping around can often get you a better deal, if you consult an adviser who can access the whole of the market. The second weakness is that the annuity dies with you. Unless you have a joint-life annuity that also covers your spouse (or any other chosen individual), payments will stop after your death once the guarantee period has passed. However, many providers are now offering guarantee periods of up to 30 years, so they are trying to address this weakness to be more competitive.
Drawdown too has a major Achilles heel, which is its continued reliance on the stock market. If the markets do well, your fund may grow by enough each year to provide you with an income. But if it doesn’t grow enough, you will have to start drawing on the capital sum. The more of your capital you are forced to withdraw, the more the growth will decline, and so on in a downward spiral. A few extravagant years, or a few poorly-performing ones, can leave you on the ropes.
So who’s the winner? Drawdown or annuities? At the moment the UK public is backing drawdown, with annuity sales diving to around 12,000 a year from 90,000 two years ago. But it’s closer than you might think. Drawdown means leaving your retirement income at the mercy of the stock market, and continuing to worry about it well into old age.
Talk to a financial adviser and you can make your own decision, based on your particular circumstances. An adviser may well recommend a combination of both: an annuity to provide basic living expenses, and a drawdown scheme to cover additional spending for instance. Or you might start with drawdown and then proceed to an annuity later on. Because the fact remains: unless you’re an expert, this one is just too close to call.
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