Annuity or drawdown? Understanding the differences can help you find the right balance between security, flexibility and investment potential in retirement.
When approaching retirement, one of the biggest financial decisions you may face is how to turn your pension savings into an income.
For many people with defined contribution pensions, two of the main options are purchasing an annuity or using flexi-access drawdown.
An annuity can provide the security of a guaranteed income, while flexi-access drawdown offers greater flexibility and the opportunity to keep your pension invested. Neither is automatically better than the other – and increasingly, retirement planning does not necessarily have to involve choosing just one.
In some circumstances, a combination of annuity and drawdown can provide an attractive balance between security and flexibility.
So, how do the two approaches compare?
What is an annuity?
An annuity converts some or all of your pension fund into a regular income.
A lifetime annuity normally provides an income for the remainder of your life, irrespective of how long you live. This removes both investment risk and the risk of exhausting the pension fund used to purchase the annuity.
There are many different ways an annuity can be structured.
For example, you may be able to choose:
- a level or increasing income;
- an income payable for your lifetime only;
- an income continuing partly or fully to a spouse or partner after your death;
- a minimum guaranteed payment period; or
- capital or value protection.
Your age, health, lifestyle and the options selected can all influence the income available. Certain medical conditions or lifestyle factors may also qualify you for an enhanced annuity, potentially providing a higher income.
Importantly, you do not normally have to purchase an annuity from your existing pension provider. Shopping around and comparing the available market can therefore be extremely important.
You may find the following article on the Money Helper website of interest: Compare annuities: get a guaranteed retirement income
What is flexi-access drawdown?
Flexi-access drawdown takes a very different approach.
Instead of exchanging your pension fund for a guaranteed income, the remaining pension money stays invested.
You can then make withdrawals from the pension to suit your requirements.
Depending upon your circumstances, this could mean taking:
- a regular monthly income;
- occasional lump sums;
- different levels of income at different stages of retirement; or
- no income at all for a period.
This flexibility can be extremely useful, particularly where expenditure changes throughout retirement.
However, because the pension remains invested, its value can fall as well as rise and the future income it can provide is not guaranteed.
You may find the following article on the Money Helper website of interest: Take money from your pension when you need it: pension drawdown explained
Annuity vs drawdown – the key differences
| Annuity | Flexi-Access Drawdown | |
|---|---|---|
| Income security | Lifetime annuity can provide guaranteed income for life | Income is not guaranteed |
| Investment risk | Generally removed once the annuity is purchased | Pension remains exposed to investment risk |
| Flexibility | Usually limited once established | High – withdrawals can normally be varied |
| Access to capital | Usually surrendered in exchange for the annuity benefits | Remaining fund remains accessible |
| Longevity risk | Lifetime annuity protects against outliving the income | Fund could potentially be exhausted |
| Growth potential | Generally no access to investment growth after purchase | Remaining pension continues to participate in investment returns |
| Death benefits | Depend upon the options selected when the annuity is established | Remaining pension can normally be passed to beneficiaries, subject to pension and tax rules |
| Ongoing management | Generally relatively little required | Investments and withdrawals need ongoing monitoring |
| Ability to change strategy | Usually limited | Considerably greater |
These differences explain why the right retirement income strategy depends upon much more than simply comparing which option provides the highest starting income.
The case for an annuity
Perhaps the greatest attraction of a lifetime annuity is certainty.
Knowing that a particular level of income will continue for the rest of your life can make retirement planning considerably easier.
This can be particularly valuable where the income is being used to meet essential expenditure such as household bills, food and other regular commitments.
An annuity may therefore appeal to someone who:
- places a high value on income security;
- does not want their retirement income dependent upon investment markets;
- has limited other secure income;
- is concerned about their pension fund running out;
- does not require substantial future flexibility; or
- may qualify for an attractive enhanced annuity because of their health or lifestyle.
There can also be a significant psychological benefit. Some people simply feel more comfortable knowing that their essential income will arrive every month regardless of what happens to investment markets.
The disadvantages of an annuity
Security inevitably involves compromises.
Once a conventional lifetime annuity has been purchased, the decision generally cannot be reversed and the capital used to purchase it is no longer available to you.
The income may also lose purchasing power over time if you choose a level annuity and inflation subsequently increases living costs.
Inflation-linked or escalating annuities can help address this risk, although the initial income will normally be lower than an equivalent level annuity.
Death benefits also need careful consideration. An annuity designed purely to maximise an individual’s lifetime income may cease on death. Options such as a spouse’s pension, guarantee period or value protection can provide additional protection, but will usually affect the starting income available.
The case for flexi-access drawdown
The greatest attraction of drawdown is flexibility.
Retirement expenditure is rarely identical every year.
You might spend more during the early years of retirement on travel and leisure, require less income later, or need occasional larger withdrawals for a new car, home improvements or helping family members.
Drawdown can accommodate these changing requirements.
It also allows the remaining pension to stay invested, providing the potential for future investment growth.
This may be particularly attractive for someone retiring relatively young whose pension may need to support them for 20, 30 years or potentially even longer.
The risks of flexi-access drawdown
Flexibility does not remove risk – it changes the type of risk you accept.
With drawdown, the pension remains invested and its value can therefore fluctuate.
One particularly important consideration is sequencing risk.
If investment markets fall significantly during the early years of retirement while withdrawals are also being made, a pension can suffer disproportionately. Investments may have to be sold at depressed values to provide income, leaving less capital available to participate in a subsequent recovery.
There is also longevity risk – the possibility that you live considerably longer than anticipated and your pension therefore has to provide an income for much longer.
For these reasons, a drawdown strategy should not simply involve deciding upon an income at retirement and then forgetting about it.
The level of withdrawals, investment performance, remaining pension value and changing personal circumstances should all be reviewed regularly.
Cash reserves can play an important role
One way of managing some of the short-term investment risk associated with drawdown is to maintain an appropriate cash reserve.
Rather than having to sell investments every time income is required, sufficient cash can potentially be held to meet nearer-term expenditure.
Other portions of the retirement portfolio can then be invested with different time horizons in mind.
This does not eliminate investment risk, but it can help avoid becoming a forced seller of longer-term investments simply because markets happen to have fallen when income is required.
The appropriate structure will depend upon the individual, their expenditure requirements, other sources of income and attitude towards investment risk.
Does it really have to be annuity or drawdown?
No.
This is perhaps one of the most important points when comparing annuities and drawdown.
Retirement planning does not necessarily require an all-or-nothing decision.
For some people, combining guaranteed and flexible income can provide the best characteristics of both approaches.
For example, part of a pension might be used to purchase an annuity providing sufficient guaranteed income to help meet essential expenditure.
The remainder could then stay invested through flexi-access drawdown, providing flexibility, access to capital and the potential for longer-term growth.
Another possibility is a fixed-term annuity, which can provide guaranteed income for an agreed period rather than necessarily committing the pension to a lifetime annuity.
At the end of the term, a maturity value may be available to help fund the next stage of the retirement strategy.
This can be useful where someone’s circumstances are likely to change – perhaps because State Pension or another source of guaranteed income will commence later.
Tax also matters
Pension withdrawals need to be considered alongside your other taxable income.
Although pension commencement lump sums can normally be taken tax-free within the applicable allowances, subsequent pension income is generally subject to Income Tax.
The flexibility offered by drawdown can sometimes allow withdrawals to be planned across different tax years, potentially helping to manage the amount of tax payable.
However, taking taxable flexible pension income can also trigger the Money Purchase Annual Allowance (MPAA), which can significantly restrict the amount that can subsequently be contributed to defined contribution pensions while benefiting from tax relief.
This can be particularly important for people who continue working after accessing their pensions.
Tax rules and allowances can change, and their effect will depend upon individual circumstances.
What happens in the event of death?
Death benefits are another important part of the comparison.
With an annuity, what happens after death depends upon the options selected when it was purchased. A spouse’s or dependant’s income, guarantee period or value protection may provide benefits after death.
With drawdown, any remaining pension fund can generally be passed to nominated beneficiaries, subject to the rules applying at the time.
There is, however, an important forthcoming change.
From 6 April 2027, most unused pension funds and pension death benefits will be included when determining the value of an individual’s estate for Inheritance Tax purposes.
This represents a significant change from the previous treatment of many pension death benefits and means that retirement and estate planning may increasingly need to be considered together.
The precise tax treatment will depend upon the circumstances at the time of death and the prevailing legislation.
So, which is better – annuity or drawdown?
There isn’t a universal answer.
An annuity may provide something extremely valuable: certainty.
Drawdown provides something quite different: flexibility and continued investment potential.
For many people, therefore, the more useful question is not:
“Should I choose an annuity or drawdown?”
but:
“How much of my retirement income needs to be secure, and how much flexibility do I want with the remainder?”
That can lead to a very different retirement strategy.
Someone with substantial State Pension, defined benefit pension or other secure income may be comfortable retaining more investment risk within drawdown.
Someone whose pension savings need to meet most of their essential expenditure may place considerably greater value on guaranteed income.
And for someone between those two positions, a combination of annuity and drawdown may be worth considering.
Retirement income planning should be personal
The decision should ultimately be based upon your wider financial position rather than one pension viewed in isolation.
Important considerations can include:
- your required level of retirement income;
- essential versus discretionary expenditure;
- other pensions and sources of guaranteed income;
- your age and health;
- your attitude to investment risk;
- your capacity to withstand investment losses;
- how long your pension may need to last;
- your need for access to capital;
- tax considerations; and
- your wishes for your spouse, family or other beneficiaries.
Cashflow modelling can also help illustrate how different levels of income, investment returns and life expectancy could affect your finances over the course of retirement.
The objective is not simply to generate the highest income today. It is to build a retirement income strategy that has an appropriate balance of security, sustainability and flexibility for the years ahead.
Need help deciding between an annuity and drawdown?
At LFP Asset Management, retirement planning forms an important part of the advice we provide.
We can help you assess your existing pensions, income requirements and wider financial circumstances before considering the different retirement income options available.
Where appropriate, this can include annuities, flexi-access drawdown, fixed-term annuities or a combination of different approaches.
The aim is to build a retirement strategy around your circumstances and objectives, rather than trying to fit your retirement around a particular pension product.
Annuity vs Drawdown FAQs
Neither option is automatically better. An annuity can provide a guaranteed income for life, while flexi-access drawdown offers greater flexibility and keeps your pension invested. The most suitable option depends on your income needs, attitude to risk, other retirement income and personal circumstances.
Yes. You do not necessarily have to choose one or the other. Part of a pension can potentially be used to purchase an annuity to provide guaranteed income, while the remainder stays invested through flexi-access drawdown. For some people, this can provide a useful balance between security and flexibility.
Yes. Money held in flexi-access drawdown can generally be used to purchase an annuity later. This can be useful because retirement needs can change over time and annuity rates are influenced by factors including your age, health and market conditions at the time.
Generally, purchasing a lifetime annuity is a long-term decision that cannot simply be reversed later. It is therefore important to consider the available annuity providers and options carefully before proceeding.
Any money remaining in a drawdown pension can normally be passed to nominated beneficiaries, although the tax treatment depends on the circumstances and the rules applying at the time. From 6 April 2027, most unused pension funds and pension death benefits are due to be included when determining the value of an estate for Inheritance Tax purposes.
Flexi-access drawdown generally allows considerable freedom over the amount and timing of withdrawals. However, taking too much too quickly can increase the risk of the pension running out, particularly if withdrawals coincide with periods of poor investment performance.
It can. Taking taxable flexible income from a defined contribution pension will normally trigger the Money Purchase Annual Allowance (MPAA), restricting the amount that can subsequently be contributed to money purchase pensions while benefiting from tax relief. Simply taking tax-free cash does not necessarily trigger it.
Retirement income decisions can have long-term consequences and may involve investment risk, taxation, death benefits and the sustainability of future income. Regulated financial advice can help assess these issues alongside your wider financial circumstances and objectives.
Important Information
This article is for general information only and does not constitute personal financial, investment or tax advice.
The suitability of an annuity, flexi-access drawdown or any other retirement option will depend upon your individual circumstances, objectives and needs.
With flexi-access drawdown, your pension remains invested. The value of investments can fall as well as rise and you may get back less than you invested. Withdrawals can reduce the value of your pension, particularly during periods of poor investment performance, and there is a risk that your pension fund may not last for the whole of your retirement.
Annuity rates and the income available can change. Once a lifetime annuity has been purchased, it generally cannot be changed or surrendered, so it is important to consider the available options carefully before proceeding.
Tax treatment depends upon individual circumstances and may be subject to change in the future.
If you are unsure about your retirement options, you should consider seeking regulated financial advice.