Should I use income drawdown or buy an annuity with my pension pot?

Clients are always asking us if they should use their pension pot to buy an annuity or take the slightly more modern flexible access drawdown.

Buying an annuity generally provides a secure, guaranteed income for life.

It’s a financial tool designed to replace capital (the value of your pension pot, after taking any tax-free cash entitlement) with an regular income for the rest of your life.

You can add different options when buying an annuity, including indexation of the income (so it increases each year to keep pace with price inflation), a benefit for your spouse or civil partner in the event of your death before theirs, and a guarantee period where the annuity income will continue to be paid for the remainder of that term, perhaps five or ten years after you purchased the annuity.

Annuity bought with a pension pot has historically been the more popular choice.

However, following the introduction of pension freedoms in April 2015, combined with rising life expectancy and falling gilt yields (government bonds are a commonly used investment made by insurance companies to secure annuity income, so when yields are lower, annuity rates tend to be lower too) and other factors made buying an annuity less attractive.

But what about income drawdown or, to give its proper title, flexible access drawdown?

This retirement income involves maintaining your pension pot invested and drawing an income from that invested pension pot. This does involve some element of risk.

There is the risk that any investments within your pension pot can fall in value. There’s also the risk that the amount you withdraw from your pension pot can be unsustainable, with the value of your pot reducing over time and worst case scenario, you run out of cash before you die.

These risks mean that flexible access drawdown tends to suit best those who are prepared to and able to take investment risk.

It might be suitable for you if you have other sources of income or capital which you can use to cover your essential expenditure in retirement.

Flexible access drawdown is also more likely to appeal to those with previous investment experience, rather than novice investors who are unfamiliar with the volatility they are likely to experience.

There is still a useful role for annuity purchase as a retirement income option.

Despite relatively low annuity rates, buying an annuity is a good way to get financial peace of mind, which is especially important in later retirement when you are less likely to want to make important investment and financial decisions on a regular basis. Of course you can always mix and match buying an annuity with flexible access drawdown; it doesn’t need to be an ‘either, or’ situation.

There’s a good argument for buying an annuity with part of your pension pot in order to secure essential expenditure in retirement, and then leaving the balance of your pension pot invested so you can use flexible access drawdown to cover additional spending.

Anyone who starts their retirement income strategy with flexible access drawdown should be reviewing the annuity purchase option at regular intervals, as there is likely to be a time when securing your income with an annuity purchase becomes more attractive than continuing with flexible access drawdown.

What really matters though is having a comprehensive financial plan in place that covers your goals in retirement. Buying an annuity or using flexible access drawdown should never be considered in isolation. Instead, you should be factoring in your income, expenditure, assets and liabilities, modelling these through to the end of your life using reasonable assumptions about the future.

As always, you should seek professional financial advice before making any decisions.