Annuity vs Income Drawdown: What’s Best For Your Retirement
When your retirement starts, the biggest concern is usually where to put your pension income to ensure it lasts you for as long as possible. Therefore, it’s important that you settle for an ideal option to secure your savings and afford a sustainable income throughout your golden years.
This is where the debate of annuity vs income drawdown comes in. Annuities and income drawdowns are the primary options that allow individuals to receive funds on a methodical basis from their pension benefits. However, each has disparate advantages and risks, and it’s vital to assess these up before settling for either.
This side-by-side comparison of annuity vs income drawdown will help you decide which model is perfect for you.
Learn more about retirement: 5 Key Steps to Safe Retirement Planning
What Is an Annuity?
An annuity is a customizable insurance contract provided by financial institutions. It provides the retiree with a fixed income stream for the rest of their life or a specified period. They provide a steady cash flow by converting a lump-sum premium into a stream of income. You can obtain an annuity by tapping into all or a portion of your pension savings.
Moreover, one can optimize annuities for income or long-term growth. As such, an annuity is not a suitable short-term investment strategy, making it ideal for individuals searching for:
- long-term financial security
- retirement income
- diversity and,
- principal safeguarding.
There are several types of annuities. Some pay a fixed income, earn interest based on a market index, and others make interest through selected investments within a pension. In addition, annuities undergo the accumulation and annuitization process. As the name gives it away, the accumulation phase is when an annuity becomes funded before the payments begin. On the other hand, the annuitization stage starts once the payments start.
In essence, annuities are either immediate or deferred. The former doesn’t necessarily require an accumulation phase since individuals or retirees who have received a lump sum exchange it for future cash flows. Deferred annuities entail buying a premium that will grow on a tax-deferred basis through the accumulation phase. Then come to the annuitization stage; individuals will receive guaranteed and regular payments as dictated on the terms of their contract.
It would be best to scrutinize all the options offered by insurance companies or your pension provider and seek financial acumen before buying an annuity plan.
An income drawdown fund is an arrangement that allows retirees to reinvest their retirement benefits through an investment fund. In return, they can access their pension funds as regular income. It keeps your pension invested and offers you the flexibility to determine your retirement income.
Instead of using your pension pot to purchase an annuity, income drawdown allows you to invest your funds and take a regular income directly from the fund. If your investments are lucrative, your pension fund will keep on growing, consequently increasing your retirement income. Conversely, your income value might decrease if your investments bite the dust.
There are various types of income drawdown. The most prevalent, Flexi-access drawdown, allows retirees unlimited access to their access fund. Still, to ensure one doesn’t exhaust all their funds and provide cover for longevity, most schemes cap the amount withdrawn from the fund annually at a certain percentage of the fund balance.
Annuity vs Income Drawdown: How Do They Compare
As already outlined, annuity and income drawdown are primary options for drawing money from your pension. The significant difference between these models is that drawdown allows your pension fund to keep on growing. In contrast, annuity lacks investment value and no pension pot to benefit from growth. Still, there is a lot more.
Here are other factors that differentiate these models:
The most notable benefit of an annuity is that you are eligible for income for the rest of your life or a given period. On the other hand, your retirement benefits are vulnerable to market performances for income drawdown, and might not last for the desired period if your investments fall through. In addition, with income drawdown, it rests entirely on you to decide if your pension pot can last for the rest of your life. Also, funds might get depleted if a pensioner lives longer than expected.
There is no doubt income drawdown tends to be more flexible than an annuity. It’s almost impractical to change an annuity once you purchase it. As such, it’s vital to set the proper income amounts and payment frequency to avoid inconveniences. On the other hand, income drawdown allows members to alter the value of their withdrawals to suit their current situation.
Moreover, pensioners can stop, start and change income levels at any time. Of course, this carries significant risks since, without adequate management and planning, you might find yourself exhausting all your benefits in a short period.
3. Investment Returns
Perhaps the most lucrative aspect of income drawdown is that members can enjoy investment returns if they invest their funds conservatively while preserving capital and achieving continued growth. Even better, pensioners might still have funds to continue providing for themselves or their kin at the end of the drawdown period. Still, your investment pot can go down in case of poor investment performance.
For annuities, financial institutions or insurance companies only pay the interest rate stipulated under the contract. In most cases, the interest rate depends on the current rates when determining the regular payments. On a positive note, you don’t have to worry about any investment risks.
In the event of demise, an annuity contract becomes obsolete and will pay no more unless the member purchased other benefits when setting up the annuity. Single-life Annuity only pays income to the pensioner, and the insurer keeps the remaining funds in case of death. Sounds harsh right? Still, you can consider buying a joint-life annuity at extra costs and nominate a beneficiary to receive income payments on your behalf in case of death.
On the flip side, income drawdown allows members to nominate a beneficiary to receive their pension if they die. What’s better, if the pensioner passes on before a certain age, 75 in most cases, the beneficiary will receive the remaining contribution tax-free according to their preferred mode. That is, as a lump sum or ascended through drawdown. Likewise, if the member passes on after age 75, the beneficiary can also access the funds flexibly only to be eligible for tax deductions.
Annuity vs Income Drawdown: Which Should You Consider
Ultimately, the perfect model for your retirement plan comes down to the prevailing circumstances and your objectives. For instance, an annuity would be a favorable option if you have no underlying condition and expect to live until the declining years. Likewise, if you don’t want the burden of managing your pension benefits and your spending needs will likely remain constant, an annuity would be the suitable model.
On the other hand, if you want to leave for your kin a significant inheritance in case you pass on prematurely or you expect your spending needs to change over time, income drawdown might be a convenient alternative. Also, individuals willing to take the risk in return for potentially higher incomes should opt for income drawdown.
Most importantly, if you have a substantial pension fund, there is no reason you can’t use annuity and income drawdown in a complementary manner. A combination of the two options enhances your flexibility and security. All in all, it would be best to seek the insight of a financial advisor who will talk you through all the risks and benefits and recommend the perfect option in light of your requirements and circumstances.