Annuity vs. Drawdown: Dispelling the myths

In recent months, the media has reported that many pension savers are continuing to opt for annuities as their primary retirement investment.

The recent ABI pension freedom statistics show that the proportion of people purchasing annuities has jumped back up and is now nearly on a par with drawdown. This is in contrast to 12 months ago (April 2015), when the government introduced the new pension freedoms and drawdown quickly seemed like the most popular option. In fact the ABI reveals that in the last quarter of 2015 annuities were more popular with new customers than drawdown, 21,200 sold compared to 19,700 drawdown policies.

The initial drop in annuity purchase after the freedoms came into effect was not a surprise. The lead up to the launch of the government’s pension reforms created a pent-up demand in the market, resulting in many deferring the opportunity to take annuities, and instead opting to drawdown a lump sum as soon as the reforms came into force.

What has perhaps been surprising since is the reversal of that trend, with many people now opting again for the perceived security of annuities. This could be partly in response to recent economic uncertainty and stock market falls. If an individual in their first year of drawdown took a significant hit on their fund, it could be hard to recover the loss if they are making withdrawals as well, and knock their confidence in managing their investment. Some schemes’ have also been reluctant to make drawdown an easy option for their members. Many people may be less sure of what the right choice for them is.

Do annuities or drawdown offer better value and return?

There are a lot of commonly held preconceptions about both annuity and drawdown. The important thing is that savers must be fully informed when it comes to their pension choices. Below, I will look at what savers need to consider before making their choice.

Annuities

Although annuities offer a guaranteed income for the remainder of your life, for yourself and your dependents, they are not without their drawbacks. The key problem being that the total value (in monetary terms) of an annuity, and all subsequent payments, are determined by conditions at the time of purchase.

In today’s market, annuities are not competitively priced. They also offer limited flexibility in payments, with only limited pension increases and payment patterns allowed. While annuities do deliver a reliable income stream for life, their value is volatile and they tie people into an arrangement for life (although this is set for change).

Essentially, annuities offer security and good value for those who live a long time and do not have any interest or confidence in managing their funds, however they are a poor return for those whose retirement ends earlier than expected.

Drawdown

Drawdown arguably offers better value than annuities in the current market. A major incentive for many choosing drawdown is the fact that savers can choose to invest some of the money in their drawdown funds into investments that can provide a better return than annuities. This could be any of a number of options including property, corporate bonds, equities or diversified growth funds.

However, returns can be volatile, with success not guaranteed. This can be a downside for many savers. As drawdown places more responsibility on the individual, it does require a basic understanding of investments, close management and an understanding of how to make money last. However, if members are happy to take on more risk themselves (including longevity risk) they can achieve good returns.

The drawdown option also delivers flexibility for members, for instance more can be taken in early retirement when people are more active.  There is also the opportunity to leave remaining funds for inheritance purposes or to buy an annuity in a few years when they may offer better value. 

Drawdown is seen as an increasingly attractive alternative for individuals. By drawing down some funds, it doesn’t rule out members taking the option of purchasing an annuity later down the line, when needs are more predictable and they are less inclined to be active in investment decisions.

So how can you tell what the best option is?

Ultimately an individual’s circumstances, their priorities and the advice they seek will be what dictates their final decision as to what is best for them. But right now, annuities should not be considered the ‘default’ for people who have worked and saved hard. It makes sense that many are looking to have at least some of their income in retirement available straightaway as drawdown, which does not preclude buying an annuity later in life.

The benefit of the pension reforms is that they have modernised the market and given people greater choice and freedom to decide how to use their pension savings. Now there is a need to make sure people are thoroughly educated on each option before they decide the best course for them.