Choosing an annuity or drawdown is one of the biggest financial decisions you’re ever likely to make. These are the two main options when converting a pension pot into a retirement income.
While an annuity pays you a guaranteed, regular income during your later years, drawdown is more flexible. It allows you to keep your pension invested and take payments on an ad-hoc basis.
Understanding the difference between an annuity and drawdown is key to putting your retirement finances on the strongest possible footing. Read on to explore the potential advantages and disadvantages of each – and which might be best for your circumstances.
What’s the difference between an annuity and drawdown?
Annuities and drawdown are both products that help retirees turn the private pension savings they’ve built up over their career into a manageable income. Their main difference revolves around how this income is paid.
How does an annuity work?
Buying an annuity effectively allows you to trade in your pension pot for a regular income in retirement. The aim is to provide you with guaranteed payments at regular intervals to stop you running out of cash.
Annuities are mainly an option for defined contribution scheme members. They can last for:
- The rest of your life. Products known as lifetime annuities offer peace of mind by making payments until you pass away.
- A specific period. Fixed-term annuities give you the opportunity to receive payments for as little as one year, or multiple decades.
Advantages of buying an annuity
Annuities offer a range of potential benefits, including:
- No hidden surprises. With guaranteed payments, you won’t need to worry about economic disruption or stock market swings. This is a major difference between an annuity and drawdown.
- Tailored options. ‘Level’ annuity products are designed to pay you a fixed amount, while ‘escalating’ annuities increase payments as the years roll on. If you face a shorter life expectancy due to underlying medical conditions, an enhanced annuity might offer larger payments.
- A regulated income. No one knows exactly how long their retirement will last. Annuities can stop you running short of money as the years pass.
- Limited management. Annuities can take the strain out of money management, with your pension provider or insurance firm monitoring payments for you.
What to be careful of with annuities
On the flipside, annuities won’t be right for everyone, as these potential drawbacks show:
- Inheritance uncertainty. Basic annuity packages may not pass your remaining pension pot to loved ones after you die.
- Little room for manoeuvre. Your annuity terms and income are decided when you purchase a product, making it hard to change your mind further down the line.
- Lack of growth potential. An annuity, unlike drawdown, doesn’t require you to invest any money. While that can shield you from market turbulence, it also prevents you from enjoying investment growth.
How does drawdown work?
Drawdown offers a more flexible approach to retirement than an annuity. Instead of exchanging your retirement savings for a regular, guaranteed income, your pension pot stays invested in the stock market.
You’ll benefit from any investment growth and gain more freedom over when you draw an income from your pot. You can opt for regular payments or take money as and when it’s required.
Advantages of using drawdown
The main advantages associated with drawdown products include:
- Flexibility. Compared to the rigid terms of an annuity, drawdown gives you the power to alter the regularity and size of your payments.
- Potential investment growth. A strong performance in the markets could increase your retirement income over time.
- Ability to pass on money. Your family should receive any funds left in your pension pot when you pass away.
What to be careful of with drawdown
Despite their many advantages, drawdown products might not be a perfect fit. The potential negatives include:
- A lack of guarantees. Your investments are at the whim of the markets and could fall as well as rise.
- Active money management. You’ll need to keep a close eye on your withdrawals to ensure you don’t run out of cash in the future.
- Investment charges. Fees and charges to keep your money invested could eat into the value of your pension pot if you’re not careful.
Which is better annuity or drawdown?
Your decision on whether to choose an annuity or drawdown will ultimately boil down to your personal circumstances.
Annuities are designed more for retirees seeking a stable, regular income that can sustain them until the end of their life. In comparison, drawdown hands you access to the stock market, giving your pension pot the opportunity to grow. The compromise? You’ll have to trade in the reassurance offered by an annuity for a degree of investment risk.
Think carefully about your risk appetite, the size of your pension pot, and how actively you want to manage your money before committing to any deal. Setting up a retirement income is a huge decision – and one that should never be rushed.
Annuity and drawdown as a blended solution
It’s worth bearing in mind that with pension freedoms, you don’t need to choose just one option - you could use a mixture of options as part of a blended solution. This is becoming increasingly popular as a way to achieve the perfect balance of security and flexibility. It means you could place some of your pension pot in an annuity with guaranteed income and leave the rest invested in a drawdown solution so that it can continue to grow.
Need personalised guidance on which option might work better for you or as part of a blended solution? Just get in touch with our retirement advice service. They can help you understand your options and which might be right for your individual circumstances.
What age should I buy an annuity?
You can generally buy an annuity from the age of 55, which is the earliest most people can access their pension pot. Some providers may limit the age at which you can purchase one of these products, for example at age 75.
Can I withdraw money from an annuity?
It’s usually very difficult to withdraw money from an annuity or change the terms of a contract. You should be able to change your mind if your provider offers a ‘cooling off’ period. But annuities are usually set in stone once that window closes