The Office for National Statistics revealed in 2019 membership of Defined Contribution (DC) pension schemes exceeded 22 million policies. Annuity and drawdown are two options open to you when you want to access or withdraw from your DC (defined contribution) pension pot but there are differences.
The main difference between an annuity and drawdown is that an annuity guarantees the same payment for a fixed term while drawdown allows you to access your pension at any time and draw as much money as you need.
Before the pension freedoms 2015, over 90% of pension savings were used to buy annuities. However, drawdown sales are now twice that of annuity sales.
| Year | Number of Annuities | Value of Annuitites (£000) | Number of Drawdown | Value of Drawdown (£000) |
|---|---|---|---|---|
| Apr 2018 – Sep 2018 | 37,990 | 2,342,790 | 95,380 | 14,851,466 |
| Oct 2018 – Mar 2019 | 35,987 | 2,181,929 | 98,328 | 13,591,829 |
| Apr 2019 – Sep 2019 | 38,381 | 2,381,600 | 101,625 | 14,721,069 |
| Oct 2019 – Apr 2020 | 31,138 | 1,848,102 | 95,493 | 13,499,680 |
Source: Financial Conduct Authority
With more people opting for drawdown understanding the difference between annuities and drawdown is only part of the picture. You need to be clear on how all your assets work together to provide you with the income that you need to support your lifestyle for the rest of your life. Our expert financial planners based in the UK can provide advice on pension and retirement planning, giving you peace of mind everything is going to be ok.
What is pension drawdown?
Pension drawdown is one way of accessing your pension funds from age 55 onwards. You can access 25% of your pension pot tax free and will pay income tax on the remaining 75% at your marginal rate.
| Advantages of Drawdown | Disadvantages of Drawdown |
|---|---|
| Investment potential – After you reach retirement age, your pension account has the potential to grow even more. | No guarantees – You have to make sure that you don’t run out of money. |
| Control – You might adjust how much you withdraw and purchase an annuity at a later date if needed, making it more flexible than an annuity. | Investment risk – The value of your pot can go up or down as it remains invested. |
For more information on drawdown please check out our guide ‘What is pension drawdown?’
What is a pension annuity?
You buy an annuity from an insurance provider using money from a defined contribution pension and they pay you an agreed amount over a specific period of time. Once you buy an annuity you can’t change your mind. It’s best to shop around because insurers will offer you different rates based on what they believe the level of risk is.
| Advantages of Annuities | Disadvantages of Annuities |
|---|---|
| Guaranteed – You get a guaranteed annuity income for the rest of your life. | Inflexible – There are no refunds when you buy one. |
| Simple – You know exactly how much you’re going to get from day one. | Rigid – Your pot has no chance to grow as it has no investment value. |
| Customizable – There are lots of options to make sure you get the most out of your annuity | It dies with you – You have to get the right annuity for you otherwise your loved ones won’t receive anything when you pass away. |
For more information please check out our guide ‘What is an annuity pension?’
What are the differences between an annuity and pension drawdown?
The way we think about annuities and pension drawdown at Joslin Rhodes makes them fundamentally different options. We use the ‘box’ and ‘barrel’ analogy to explain what they are and how they work.
Annuity – The ‘Box’
An annuity pays out regular monthly income for the rest of your life or agreed term. Imagine a secure box of cash that paid you out a fixed amount each month. Typically used to cover fixed costs e.g. utilities.
The annuity is like a box because it’s secure and guaranteed. You can’t ever open the box and change the amount.
Drawdown – The ‘Barrel’
Drawdown is a method of withdrawal typically used to fund large purchases. Think of it as a barrel with a tap at the bottom that you can access and open anytime.
The key differences between pension drawdown and annuity are related to:
- how flexibly you’d like to access your money
- your appetite for investment risk
- whether you hope to leave an inheritance, known as a death lump sum
- how you perceive your pension pot
| Annuity | Drawdown | |
|---|---|---|
| Access and Flexibility | You can’t access your full pension pot, you just receive guaranteed income payments | You can access any amount of your retirement income, as and when you want to |
| Income | You receive a regular, predictable income for the rest of your life, or an agreed term | You have no guaranteed income and need to actively manage your money |
| Risk | You are guaranteed a certain income – you have zero investment risk | The value of your pension pot may go up or down, depending on your investments |
| Inheritance | Your spouse may be able to continue to receive payments after you die, until their death, but usually there is nothing to pass on to children | When you die, your remaining pension pot can be distributed to your loved ones in the form of a death lump sum |
| Perception | You are more likely to perceive your pension as ‘income’ and be happy to spend it | You may perceive your pension as ‘savings’ and be scared to spend them |
| Tax | Annuity income is treated as employment income so you pay income tax if your total income is above the income tax threshold. | Income drawdown taken directly from the pension fund is also treated the same as employment income. So if you take all your remaining funds in one go, that (along with any other taxable income you had) would state what income tax rate you pay on the fund. Payments are made with or without ‘proportion.’ When you die, if you choose “with proportion,” a percentage of your next income payment is paid. It’s based on how many days have passed since your last payment and the date of your death. |
You don’t have to choose one or the other. It’s possible to combine a box and a barrel approach. For example, splitting your pension pot equally between the two, giving you a balance of regular income alongside flexible access to larger sums if needed.
You should always seek financial advice before making a final decision.
Is an annuity better than a lump sum?
A lump sum is when you withdraw a specific amount of money from your pension pot in one go.
An annuity is different to a tax-free lump sum. You might use your annuity income to cover your foundation costs, things like your mortgage and insurances.
Taking a lump sum gives you the option to make one-off large purchases or go on holidays that you normally couldn’t afford. It’s always worth speaking to an independent financial adviser to find out what’s best for you and your circumstances.
To find out more about lump sum’s check out: Is my pension lump sum taxable?
When you buy an annuity, the provider will tell you that you have a 30-day cooling-off period. You can change your mind at this time and tell the annuity provider, usually in writing, that you don’t want to go ahead.
That’s not the same as cashing in your annuity. If you’ve passed your cooling off period it’s highly unlikely that you’ll be able to cash in.
Annuity, Drawdown or Cash?
There’s no one size fits all answer to whether annuity, drawdown or tax free cash lump sum is the best way for you to go.
It always comes down to your unique circumstances and most importantly what you want from life now and in the future. Once you’ve got a firm understanding of what you want we’ll be able to find the best approach for achieving that you can get in touch below to find out more. For further reading on potential ways, you can access your pension you can visit. Some of the topics below…
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Peter Chadwick
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FAQs
What is the difference between drawdown and annuity? ›
Annuity and drawdown are the two main options for drawing money from your pension. When you purchase an annuity, you usually receive a set income for life. If you choose drawdown, you withdraw money from your pension pot, the remainder stays invested and can go up and down in value.
Which is better annuity or drawdown? ›An annuity provides certainty in retirement, but lacks the flexibility drawdown can provide. Once you purchase an annuity there's no turning back – income amounts and payment frequency are set in stone so it's essential to ensure you purchase the right annuity to suit your needs.
What is the drawdown rule? ›The 4% rule is an attempt to do just that: it's a long-established rough estimate of how much you can safely afford to withdraw from your pension pot during retirement. The aim is for your investment fund to last as long as you need it, with investment growth compensating for your withdrawals.
What are the disadvantages of a drawdown pension? ›- Pension drawdown income is not guaranteed and there is a risk that you may run out of money in retirement.
- If your investments perform poorly you may need to reduce the income you take.
- You will need to regularly review your investments to ensure you are still on track.
There's no limit on how much money you can take out of your pension fund each year. The money in your pension fund needs to carry on growing to replace what you are taking out. So you'll need your fund to be wisely invested to make sure you don't lose out.
What is the best drawdown pension? ›- AJ Bell Youinvest.
- Pensionbee.
- Hargreaves Lansdown.
- Interactive Investor.
- Vanguard.
The main drawbacks are the long-term contract, loss of control over your investment, low or no interest earned, and high fees. There are also fewer liquidity options with annuities, and you must wait until age 59.5 to withdraw any money from the annuity without penalty.
What are the pros and cons of a drawdown pension? ›- Access to tax-free cash immediately.
- Flexibility to vary your income according to your requirements.
- Control the level of income tax you pay.
- Control of your investment.
- Funds benefit from investment growth in a tax-efficient environment.
- Choice not to purchase an annuity.
The flexibility of drawdown can be an advantage, but it also comes with more risks. Your income isn't secure, and you could run out of money if your investments don't perform as well as you might have hoped. It won't be right for everyone, so it's important you weigh up the risks and benefits.
What is drawdown formula? ›The Formula for Maximum Drawdown Is
M D D = Trough Value − Peak Value Peak Value \begin{aligned} MDD=\frac{\textit{Trough Value}-\textit{Peak Value}}{\textit{Peak Value}}\end{aligned} MDD=Peak Value Trough Value−Peak Value
What is an example of drawdown? ›
A drawdown is usually quoted as the percentage between the peak and the subsequent trough. If a trading account has $10,000 in it, and the funds drop to $9,000 before moving back above $10,000, then the trading account witnessed a 10% drawdown.
What percentage should I take in drawdown? ›How much should I drawdown from my pension? Experts recommend sticking to the safe withdrawal rate. It's recommended that you don't take more than 4% of your pension pot in 1 year. In theory, this leaves enough of your pension invested that the growth of your investment over time should cover any withdrawals you make.
What is the 4% drawdown rule? ›One frequently used rule of thumb for retirement spending is known as the 4% rule. It's relatively simple: You add up all of your investments, and withdraw 4% of that total during your first year of retirement.
Why is my drawdown pension losing money? ›If the investments inside your pension fund drop in value, the value of your pension pot will also dip. This can come from a number of factors, such as trends in the stock market, economic downturn or new political policies. Of course, these factors can also lead to your pension pot increasing - it's all about risk.
What happens to a drawdown pension on death? ›If you've chosen to take a flexible retirement income and are in pension drawdown when you die. Your beneficiaries can take the remaining money left as a lump sum, set up a guaranteed income (an annuity) with the proceeds or, they may also be able to continue with flexible retirement income (pension drawdown).
Can I change from drawdown to an annuity? ›Tax free pension income
Bear in mind, you could always combine income drawdown with buying an annuity. Annuity rates get better as you get older, so you could start off using drawdown, and then use some of your remaining pension money to buy an annuity later.
However, it is always recommended for investors and traders that drawdown should be kept below the 20% level. By setting a 20% maximum drawdown level, investors can trade with peace of mind and always make meaningful decisions in the market that will, in the long run, protect their capital.
How much of pension drawdown is tax free? ›Once you reach the age of 55 (57 from 2028) you can start to take money from your pension. Up to 25% of your savings can be taken tax-free, with the remaining 75% subject to income tax. The amount you pay depends on your total income for the year and your tax rate.
Can I change my drawdown pension to an annuity? ›Changing your mind
You can at any time use all or part of the money in your pension drawdown pot to buy a guaranteed income (an annuity) or other type of retirement income product that might meet your needs.
Once all the contracts are signed, and you've organised your home and life insurance, your solicitor will agree a completion date with the house seller and arrange the transfer of funds and collection of the keys to your new home.
What are the benefits of drawdown? ›
' A significant benefit of drawdown is that you retain ownership of your pension pot (unlike with an annuity, where you surrender the pot). This means that your family can inherit any unspent pension pot when you die, free of tax.