What is the difference between drawdown and annuity?

When we retire, those of us without a final salary pension face a choice over how to use the pot we have accumulated during our working lives. It is a complex decision: we need to balance getting as much value as possible out of savings, while trying to ensure we won’t run out of money. 

What is an annuity? 

Traditionally, those who did not have a final salary pension bought an annuity with their pension pot as soon as they stopped work. An annuity gives the person who purchases it a guaranteed annual income for life. 

Some annuities are inflation-linked, which means the amount you receive rises with the cost of living – this is important given, for example, how price rises have accelerated this year. Some annuities also provide for a spouse or civil partner if you die before them. 

What is drawdown? 

Income drawdown allows you to keep your pension invested after you retire. As the name suggests, you ‘draw down’ money from your pension pot to use when you need it. The rest is left invested in the hope that it continues to grow. 

Is drawdown a good idea? 

Whether income drawdown is a good idea for you will depend on your circumstances, health and attitude to risk. Drawdown gives you a more flexible income: you can take different amounts of money at different times, depending on when you need it. 

You can choose to put your pension into drawdown initially and buy an annuity later with some or all of your remaining pension. You can also buy an annuity with some of your pension and leave the rest invested. So, it is not necessarily an either/or choice.  

Annuities and drawdown get the same tax treatment. So, whether you choose drawdown or to buy an annuity, you can usually withdraw a 25% sum from your pension tax free, and withdrawals after this will be taxed at your marginal rate of income tax. 

The pros and cons of drawdown and an annuity 

Before you decide whether to put your pension into drawdown or to buy an annuity, you should weigh up the pros and cons of each. 

The advantages of drawdown:

• You can take the money when you want to, in differing amounts as required. This can be more tax efficient and allows for changing needs in retirement. 
• Your money can remain invested while you are not using it, giving it the chance to potentially grow in value and offset the eroding effects of inflation. However, past performance is no guarantee of future returns, and you may not get back what you invest. 
• Any money that is left in the account can be passed on to your family and does not usually count as part of your estate for inheritance tax purposes. 

The disadvantages of drawdown

• There is a lack of certainty. Nobody knows how long their retirement will last, and if you live longer than expected or have expensive care bills, you could run out of money. 
• If your money remains invested, it could lose value should stock markets fall, and this could affect your retirement income. 
• Your investments will need regular reviewing to ensure that you can still meet your financial goals, so you cannot simply forget about them. 

The advantages of annuities

• You know exactly how much you will receive, allowing you to plan for retirement without any danger of losing money. 
• You do not have to worry about stock market fluctuations. 
• For certain types of people, including those in poor health, an enhanced annuity can represent good value for money because it could offer higher regular payments because of your state of health.  

The disadvantages of annuities

• Annuity rates have been falling in recent years, and you may not get much income from your pension pot. However, a rise in interest rates could push annuity rates back up, as we’ve seen in 2022 so far.  
• You will not be able to pass on your pension to your family if it is tied up in an annuity. 
• Unless you buy a more expensive inflation-linked annuity, you could find that your income erodes in value over time. 
• Unless you pay more to buy a joint-life annuity, there will not be money to provide for a partner if you die first. 

How much should I draw down from my pension? 

If you decide to use pension drawdown, it is important that you do not take too much out in early retirement because you could run out of money later. 

Some experts often recommend that you take 4% of your pot each year, which in theory means that growth of the rest of your pension pot could cover the amount you’ve taken out. However, this figure may not be appropriate to your individual circumstances, so you may wish to seek financial advice. Remember, markets can also be volatile, and so the amount in your pot will change in value. 

Are there any tax implications of pension drawdown?  

You can usually take 25% of their pension tax-free. The rest is taxed at your ‘marginal’ rate of income tax when you take it out.  

Your marginal tax rate is the rate you pay on the last pound of income you earn, so you will pay more tax on some of your pension if you are earning other income at the same time, or if you take it all out at once and go over the tax threshold for paying Basic Rate Tax. 

It is often best to structure withdrawals so that you do not pay too much tax. Your options may include: 

• Taking this 25% lump sum in smaller amounts throughout your retirement to cut tax liabilities. 
• Using other savings – e.g. ISAs (individual savings accounts) – as well as your pension at various points. 
• Leaving your pension invested for as long as possible. 

If you are unsure, a financial adviser or tax specialist will be able to help with the best strategy. The Nutmeg Wealth Services team is available should you wish to book a free call. More help is also available via the Nutmeg website.  

How many times can I draw down from my pension? 

With drawdown, it is your choice how many times you withdraw from your pension. You can take the money how and when you like – but should bear in mind your tax liabilities when you do so, as well as how much is left in the pot for the rest of your retirement. 

How much annuity will £100k buy?

For many people, the decision on whether to buy an annuity will rest on calculations. The amount of money you will receive if you buy an annuity with your pension income will depend on many factors such as the age at which you buy it, your health and lifestyle, and whether you want to add inflation-linking or provision for a spouse or civil partner. 

There are several websites, such as moneyhelper.org.uk, which can help you estimate an average annuity. As an illustrated example, if you had a £100,000 pension pot and withdrew 25% of it without being taxed on gains at 65, an average annuity might give you around £6,100 in income every year. 

Which represents a better investment in 2022/23?  

The best investment for you will depend on your circumstances. Obviously, if you live a long time after buying an annuity, it could represent good value for money. But none of us has a crystal ball.  

Ultimately, the decision between drawdown and annuity rests with you, but a financial adviser or pensions expert could help you. 

Nutmeg’s pension offering

Nutmeg offers an award-winning personal pension, backed by the expertise of our in-house pension team. You can open a new one or transfer your existing pension to Nutmeg.

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. A pension may not be right for everyone and tax rules may change in the future. Please note that during any transfer, your investments will be out of the market. If you are unsure if a pension is right for you, please seek financial advice.