SNAPSHOT2 min read

Annuities or drawdown: which is a more effective choice for funding your dream retirement?

You may find it difficult to decide between annuities or drawdown to fund your retirement. Read on to learn more about the pros and cons of each option.

05/09/2023
Benchmark customer focused

In the past, annuities were a popular option for many people in retirement.

An annuity is essentially an insurance product that allows you to “buy” a guaranteed regular income during retirement using your pension savings.

However, as annuity rates fell and new pension rules allowed retirees to flexibly draw from a defined contribution (DC) pension, drawdown became the go-to option for a lot of people.

Putting your pension into drawdown means that you can start to access your funds, drawing as much or as little as you like. The rest of your money remains invested, so can potentially continue to grow too.

According to data from the Financial Conduct Authority (FCA) [1], between October 2021 and March 2022, 103,984 pensions were transferred to income drawdown, while only 31,806 were used to purchase an annuity.

But in 2023, that trend could begin to change as annuity rates are on the rise again. High levels of inflation mean that you may have to draw more funds to support your lifestyle, making the guaranteed income from an annuity more attractive.

That said, there are still significant benefits to drawdown, and it ultimately depends on your situation and goals in retirement. So you may find it difficult to decide whether an annuity or drawdown is the right choice for you.

Read on to learn more about how each option works and some of the pros and cons.

Annuity rates hit their highest level since the 2008 financial crisis

The annuity rate – the level of income you receive when you buy an annuity – is calculated based on several factors:

  • The value of your pension
  • Your age
  • Your health and life expectancy
  • Your location
  • Current market rates

This means, for example, that you may get a higher rate if you’re older or have a serious illness as you’ll likely draw the income for a shorter period. You may also draw more or less than you pay for the annuity, depending on how long you live.

However it’s the current market rates that usually have the biggest impact on the income you draw from annuities.

Annuity rates are rising at the moment, likely because of their connection to interest rates. Typically, when interest rates increase, annuity rates also rise.

On 3 August, the Bank of England (BoE) [2] raised the base rate for the 14th consecutive time to 5.25% in an attempt to bring inflation down. As a result, interest rates are rising across the board and annuity rates are at their highest level since the 2008 financial crisis.

According to Professional Adviser [3], this means that the breakeven point of an annuity – the point at which you have drawn your initial investment as income – has been moved closer by an average of five years.

So while the total amount of income that you take from an annuity depends on how long you live, a higher rate could mean that you’ll draw more than you invest during your retirement. It also means that you have a higher income to fund your lifestyle in the short term.

Annuities offer guaranteed income but may lack flexibility

In times of economic uncertainty, the guaranteed income from an annuity can be appealing. In fact, many people are concerned that they can’t comfortably fund their retirement - 64% of Brits said they were not confident about their retirement according to MoneyAge [4].

They’re likely concerned about the rising cost of living and how it might deplete their retirement savings faster than planned.

Meanwhile, buying an annuity means receiving a guaranteed income, so you don’t run the same risk of using all your savings and having nothing left.

It’s possible to purchase an inflation-linked annuity that sees the amount you receive increase over time in line with the cost of living.

That said, you typically start on a lower income if you opt for an inflation-linked annuity. This means that you have to decide between a lower income now that grows with inflation, or a higher income now that could lose its purchasing power later on.

Another potential drawback of annuities is that you spend a large portion of your pension savings, so you may not be able to pass those funds on to your loved ones when you die.

There are a few exceptions to this:

  • Joint life annuities – A joint life annuity pays an income to you and your partner. If you die, your partner will typically continue receiving your payments.
  • Guarantee periods – You can guarantee the annuity payments for a certain period and if you die before this, your estate still receives the payments until the end of the period.
  • Value protection – This allows you to protect all or part of the fund, so a lump sum is paid to your beneficiaries after you die.

It’s important to note that options such as guarantee periods and value protection will likely cost a bit more. You also don’t get the same Inheritance Tax (IHT) planning benefits that you might with a pension, which will typically fall outside the value of your estate.

Pension drawdown gives you control over your savings but could be less secure

While an annuity offers you guaranteed income, you may not have as much control over your savings as a result.

Pension drawdown, on the other hand, allows you to take as much or as little as you need to fund your lifestyle. For example, you can adjust the amount that you draw from your pension to account for factors such as inflation.

You can also pass any remaining funds in your pension to your beneficiaries when you die, and they will generally not have to pay inheritance tax on them. This might make your pension an effective way to pass on wealth, especially if you can draw on other savings and investments and leave funds in your pension for as long as possible.

This is however a higher risk of running out of savings if you draw too much from your pension early on. This could be a particular problem during the cost-of-living crisis because you’ll likely need to draw more funds to cover your expenses.

Market fluctuations can also affect your pension, potentially causing it to lose value. As a result, you may have to sell more units to generate your desired income, so you’ll use your savings faster. Your adviser can explain how this works if you’re interested.

You may be able to limit these risks if you work with a financial planner to forecast your spending and draw from your pension in a sustainable way.

That said, you cannot predict the future and unexpected circumstances could still affect your retirement income.

You may want to consider combining an annuity and pension drawdown

Ultimately, you may decide that one of these options is more suitable for your retirement goals. Equally, in many cases, you could benefit from using both annuities and pension drawdown.

Purchasing an annuity to cover your basic living expenses could give you the security you need, and then you could draw flexibly from your pension and other savings to top up your income.

Or, you may decide to buy a fixed-term annuity at the beginning of your retirement. When the term finishes and the remaining pension funds are returned to you, you could decide whether to purchase another annuity or move the pension into drawdown.

Discussing your situation with a financial planner and using cashflow planning to determine your required income can help you decide how to balance the two approaches.

Get in touch

Deciding whether to purchase an annuity or not can be challenging, and we can give the guidance you need.

Please visit our contact page or speak to your adviser.

Please note

This article is for general information only and does not constitute advice. The information is aimed at retail clients only.

A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future results.

The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates and tax legislation may change in subsequent Finance Acts.The Financial Conduct Authority does not regulate cashflow planning.

[1] 05.09.2023 Retirement income market data 2021/22 The Financial Conduct Authority

[2] 05.09.2023 Hot annuities market brings break-even point average five years closer Professional Adviser

[3] 05.09.2023 Official Bank Rate history Bank of England

[4] 05.09.2023 Two thirds of Brits not confident about retirement plans MoneyAge

Important information

The views and opinions contained herein are those of Benchmark Financial Planning. They do not necessarily represent views expressed or reflected in other Benchmark Financial Planning communications, strategies or funds and are subject to change. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable, but Benchmark Financial Planning does not warrant its completeness or accuracy. The data has been sourced by Benchmark Financial Planning and should be independently verified before further publication or use. No responsibility can be accepted for error of fact or opinion. Benchmark Financial Planning is not responsible for the accuracy of the information contained within linked sites. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Past Performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

Issued by Benchmark Financial Planning Limited. An Appointed Representative of Best Practice IFA Group Limited which is authorised and regulated by the Financial Conduct Authority, the registration number is 223112. Registered office: Broadlands Business Campus, Langhurst Wood Road, Horsham, West Sussex, RH12 4QP. Registered in England and Wales No 07572431.

Topics

Benchmark Financial Planning is an Appointed Representative of Best Practice IFA Group Limited which is authorised and regulated by the Financial Conduct Authority, the registration number is 223112. Registered office: Broadlands Business Campus, Langhurst Wood Road, Horsham, West Sussex, RH12 4QP. Registered in England and Wales No 07572431.

The Financial Ombudsman Service is available to sort out individual complaints that clients and financial services businesses aren't able to resolve themselves. To contact the Financial Ombudsman Service, please visit www.financial-ombudsman.org.uk

The guidance and/or advice contained within this website are subject to the UK regulatory regime and are therefore targeted at consumers based in the UK.