PLANNING FOR RETIREMENT

How annuities compare to pension drawdown in retirement planning

  • Shunil Roy-Chaudhuri, Personal Finance and Investment Writer
  • 25 March 2024
  • 8 mins reading time

If you’re approaching retirement, you will probably need to decide how you want to provide an income for your post-working years. Annuities and pension drawdown are two common ways to secure retirement income. This article outlines some key features of both.

What is an annuity?

An annuity is a contract between you and an insurance company that can convert your pension savings into guaranteed income. Under this arrangement you give annuity providers one or more premium payments, typically from your pension savings, in exchange for a post-retirement income stream. This income is generally paid on a monthly basis.

There are a range of options when it comes to annuities. A fixed-term annuity provides a guaranteed income for a set period of time, while a lifetime annuity guarantees an income for the rest of your life. A level annuity provides an income that remains fixed. But an increasing annuity provides an income that rises each year, perhaps at a set percentage or in line with inflation. For the sake of simplicity, we here mainly consider level annuities.

Annuity benefits

Annuities provide you with guaranteed regular income payments. Depending on the type you choose, you can receive income on a monthly, quarterly or annual basis and potentially also a lump sum.

Income payments from level annuities are set on the basis of a particular interest rate at the time of purchase. This protects you against interest rate changes and means you know exactly how much income you will receive.

Savings can be made tax-efficiently into a defined contribution pension, as long as you remain within the tax allowance limits. In a defined contribution pension, the amount of retirement funds built up depends on how much you and your employer contributed and how these pension investments performed.

Investment growth in a defined contribution pension fund is not liable for capital gains tax (although investment growth is not guaranteed and your pension fund may fall in value). But if you use your pension pot to buy an annuity, then these annuity payments will be fully liable for income tax. In contrast, there’s a 25 percent tax-free allowance with pension drawdown.

Some types of annuity pay a death benefit to a spouse or other beneficiaries, either as a lump-sum payment or a percentage of regular income payments. But in many cases annuity payments cease on the death of the annuity holder.

Annuity limitations

There are some disadvantages with annuities. First, they are inflexible: once the annuity has been purchased, it cannot be cashed in and the income cannot be adjusted, even if your circumstances change. And most annuities are not linked to investment returns. So you could receive a lower rate of income than if you left your money invested, although, once again, investment growth is not guaranteed.

Each provider will offer you a different annuity rate, with calculations dependent on its own criteria. So the income level you receive will vary across providers and it’s important to shop around for the best annuity rates.

Annuity rates also vary according to your health and lifestyle. They even vary according to your marital status and postcode. A financial adviser can help you decide which annuity best matches your goals.

What is pension drawdown?

Pension drawdown enables you to progressively take money out of your pension pot to live on during retirement. The remaining portion stays invested.

You can take up to 25 percent of your pension savings tax free as a lump sum. The remaining 75 percent is liable for income tax, whether taken as income or a lump sum. Alternatively, you could decide to take regular income payments in which 25 percent of each income payment is tax free, while the remaining 75 percent of each income payment is subject to income tax (HMRC calls this kind of arrangement ‘uncrystallised funds pension lump sums’ or ‘UFPLS’).

There is no limit to how much money you can take out of your pension fund each year. You could withdraw all of it in one go, take regular monthly or annual payments, or a series of lump sums. Each option has different income tax implications and you would need to check these carefully.

Pension drawdown benefits

A key advantage of pension drawdown is its flexibility, as you can vary the amount of income you draw down each year. It also offers the opportunity to continue to grow tax-efficiently, as your remaining pension pot will stay invested after retirement.

Drawdown can be particularly useful if you’re not planning to withdraw all of your pension straight away. This might, for example, benefit someone who intends to continue working part time. So you should consider drawdown if you want the flexibility to take sums out as and when you need them, or want to withdraw different amounts each year.

Pension drawdown limitations

Even so, there are disadvantages to pension drawdown. First, your money remains invested, so drawdown involves the risk that your pension investments may fall in value over time.

Moreover, any withdrawals above your 25 percent tax-free allowance are subject to income tax. And drawdown income is not guaranteed, so your drawdown fund could run out of money if you take too much out or your investments perform relatively poorly.

This article provides some introductory information on annuities and drawdown. But retirement is a complex area: you may, for example, want to consider using a combined annuity and drawdown approach.

A financial adviser can help you with retirement planning. At Schroders Personal Wealth, one of our key principles is to have regular reviews with an adviser. This could help ensure you make appropriate retirement choices.

Important information

Fees and charges apply at Schroders Personal Wealth.

Any views expressed are our in-house views as at the time of publishing.

This content may not be used, copied, quoted, circulated or otherwise disclosed (in whole or part) without our prior written consent.

In preparing this article we have used third party sources that we believe to be true and accurate as at the date of writing. However, we can give no assurances or warranty regarding the accuracy, currency or applicability of any of the content in relation to specific situations and particular circumstances.

The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors might not get back their initial investment.

The retirement benefits you receive from your pension plan depend on a number of factors including the value of your plan when you decide to take your benefits which is not guaranteed and can do down as well as up. The benefits of your plan could fall below the amount(s) paid in.

All information correct at the time of publishing.

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