Which is better for retirement: annuity or income drawdown?
Under 2019-20 pension rules in the UK, you are allowed to start taking money out of your pension savings once you reach 55. How you take the money, however, is another matter.
Generally speaking, you have two options. The first is to “buy” a financial product called an “annuity”; a product which provides you with a lifetime income once you retire.
The second is to keep the money invested in your pension pot and take some of it out in stages to provide you with a retirement income.
In either case, you are allowed to take up to 25% of your pension pot out as a tax-free lump sum. You are not obliged to do so, however, if you do not want to.
So, which offers a better deal for your retirement income – annuity or income drawdown?
Let’s take a brief look at each one in turn, to help answer that question.
It’s worth noting that you can sometimes combine an annuity with income drawdown (discussed below). The two are not necessarily mutually exclusive, but it helps to separate them for the purposes of comparison and discussion.
As mentioned above, an annuity is a financial product which you “buy” using some (or all) of your pension pot, to guarantee you a regular income in retirement.
These products are usually offered by different insurance companies, allowing you to shop around and compare different deals. You are not obligated to go with any annuity product offered by your existing pension provider, for instance.
Quite often, you can find much better deals elsewhere. Given that this will affect your income and lifestyle in retirement for potentially years or even decades, it is, therefore, a good idea to take your time to carefully look around and weigh up different offers from various companies.
Annuities can provide an income for a fixed period, or for the rest of your life.
The precise income you get from an annuity is influenced by a range of factors. For instance, if your life expectancy is projected to be quite short at the time you are looking at an annuity, then this could lead to you being offered an annuity with a higher income.
Other things which affect your “annuity rate” include your age, where you are resident in the country and your current lifestyle.
Some annuity products will link your income to inflation so that it increases with the rising cost of living, allowing you to retain the “real value” of your annuity income year on year.
So, what are the advantages of an annuity over income drawdown?
The biggest advantage is probably the fact that your income is guaranteed – you know what will be coming in each month during your retirement, giving you peace of mind and financial stability. If your annuity also covers the rest of your life, then this will continue indefinitely.
Certain annuities will also continue to pay out a portion of your income to a spouse or civil partner if you die before them, although this is usually a fraction of what it previously was.
The disadvantages of annuities include their typical permanence and inflexibility. Generally speaking, once you buy an annuity there is no changing your mind, and your annuity income is fixed for the rest of its duration (meaning there is no opportunity for it to go up).
So, what about income drawdown?
With income drawdown, you don’t “buy” a financial product like you do when taking an annuity. Instead, you arrange to take money gradually out of your pension pot, whilst keeping the rest of it invested.
This means your fund could continue to grow, even as you keep taking money from it. Your income might go up or down depending on the performance of your fund.
You can take out as much or as little money as you like from your pension fund, depending on the terms of your fund. However, you need to carefully plan how this will affect its long-term sustainability.
You obviously need to take out enough to be able to live on, but you don’t want to take out too much so that you run out of money quickly in retirement.
So, what are the advantages of income drawdown? One of the big ones is the flexibility you have access to. For instance, if you wanted to you could withdraw more from your pension fund later, allowing your fund to grow and relying on other income sources in the meantime.
Another big advantage of income drawdown is that you can pass on your pension to your beneficiaries as an inheritance. If you die before the age of 75, then your beneficiaries can claim your pension within two years, tax-free. If you die after that, then they can still inherit the pension but it might affect their Income Tax bill.
On the other hand, income drawdown carries more risk than an annuity, because you cannot guarantee how your investments are going to perform. Your income will not be as stable, and there is a chance you might run out of money if you do not plan carefully.
So, which is better then – annuity or drawdown? Annuities have taken a lot of criticism in recent years, especially since the government introduced the new pension freedoms. However, they still have their place for people with particular goals and circumstances.
Which option you go for is a huge decision and will affect the rest of your life in retirement. It is therefore usually a good idea to seek professional financial advice from a qualified independent financial adviser, who can help you sift through the options and help you make an informed decision.
If you would like to start that conversation with a member of our team here at Castlegate, then we invite you to contact us for a free, no-commitment consultation.