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Pension Tips

Drawdown vs Annuity

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Profile Pensions
Profile Pensions

If you’re approaching retirement, you’re probably starting to think about how much income you’ll need from your pension, and how you’ll access this money.

The two main options if you have a defined contribution or money purchase pension are:

1) Buy an annuity
2) Go for pension drawdown

Here, we explain how each of these options work to help you decide which approach might be right for you.

Annuities explained

An annuity is a type of contract with an insurance company which will provide you with an income for life in return for you handing over some or all of your pension savings.

The amount you’ll receive from an annuity depends on lots of different factors, such as your health, age and lifestyle, as these help insurers work out how long they expect you to live for. You can also take 25% as a tax-free lump sum when you purchase the annuity.

As a general rule, the lower your life expectancy, there’s a pretty good chance an annuity is likely to give you a higher annual income, whereas on the flip side, the longer you’re expected to live, it’s likely the less income (but over a longer period of time) you can expect to receive. Any payments you receive from an annuity will be subject to income tax.

Bear in mind that if you die soon after buying an annuity, your annuity income will usually die with you. There are some exceptions to this such as a joint-life annuity or a guarantee period which may be worth looking at.

Annuities with a guaranteed period provide an income for a minimum fixed term even if you die during this period. Joint life annuities are taken out with another person and guarantee that if one person dies, the surviving person will continue to receive a regular income for as long as they live.

How does pension drawdown work?

If you decide to access your retirement savings using drawdown, otherwise known as flexi-access drawdown or income drawdown, you’ll be able to take out 25% of the funds as a tax-free lump sum from the outset.

The rest of your pension stays invested, meaning you can continue to benefit from potential investment growth, but still be able to take money from it as and when you need it.

There’s a second type of pension drawdown scheme available – the pretty horrendously named Uncrystallised Fund Pension Lump Sum (sorry about that). This essentially means rather than taking a 25% lump sum payment at the start, each time you draw down money from your pension, 25% of it will be tax free, and the other 75% of each payment will be subject to income tax.

You can read more about the different ways of drawing from your pension in our recent blog ‘Should I take a lump sum from my private pension?’

Pros and cons of drawdown

Opting for drawdown can provide you with plenty of flexibility, as you can take out however much or little you want.

However, there’s a danger that if you take too much at once though, this might end up pushing you into a higher tax bracket. Many people have been hit with large tax bills as a result of withdrawing a big lump sum.

Drawdown also comes with a real risk of running out of money if you don’t manage what you’re withdrawing carefully. This means being reliant on the state pension, which will likely see a drop in your standard of living. As your pension remains invested the value of it and any income you receive can go down and up in value, so although you may benefit from any growth your pension can also drop in value.

One of the big benefits of pension drawdown is that when you die, any money left in your pot can be passed on to your family. If you die before you reach the age of 75, this money can be paid to them tax-free, but if you die after 75, they’ll usually have to pay income tax on it.

Your pension also remains invested while you are drawing from it, meaning your pension savings can continue to have the potential to grow in value during your retirement.

Drawdown money may also be protected from inheritance tax (IHT), as it’s considered to be outside your estate.

Pros and cons of annuities

The biggest advantage of an annuity is that you know exactly how much income you’re going to receive, as this income isn’t dependent on investment performance.

However, if you die soon after buying an annuity, unless you have a certain type of contract in place, your income will stop at that point.

Annuity rates can go up and down. If you buy an annuity when rates are low, and then they rise, you’ll have missed out on the chance of getting a higher income.

Annuity rates have been declining in recent years, with income from annuities falling by 4.3% since the introduction of the Pension Freedoms in April 2015. This is because people are living longer, so providers aren’t prepared to give you as much income for your pension.

Which is right for me – drawdown or annuity?

Whether you opt for drawdown or an annuity, or a combination of both, will depend entirely on your individual circumstances.

For example, if you want the security of a regular monthly income that won’t change, you might decide an annuity is right for you.

If, however, you think you want more flexibility over when and how much income you take, and are comfortable accepting that your pension’s underlying investments could fall as well as rise in value, you may prefer to go for pension drawdown.

Get pension advice

Choosing how you’ll take an income from your pension in retirement is a big decision and there are lots of options to choose from, so it’s vital to seek professional pension advice if you’re not sure which route to take.

An adviser can talk you through all the different things to consider and recommend the best course of action based on your requirements. For some free pension guidance (not advice), visit Pension Wise.