What's the Difference Between an Income Drawdown and an Annuity?

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by: BSM
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Date: Tue, 12 Apr 2011 Time: 6:39 PM
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Income Drawdown is a less common alternative way of using your pension funds to a traditional annuity. It is otherwise known as an "unsecured pension".
The option is similar to an annuity in that you can take a tax free lump sum of up to 25% of the value of your pension fund. UK has up until now mandated that you buy an annuity by the time you reach the age of 75, however the government has long been planning to scrap this requirement and the change is finally planned for April 2011. As such, the option of an Income Drawdown product is likely to become more viable. It differs from an annuity in that you retain the capital yourself and draw from it throughout retirement, and as such affords a higher level of flexibility. It also means that you are bearing the risk of running out of funds if you live longer than you expect - something that would not happen with an annuity.
Buying Time
In the case that you choose to use Income Drawdown to fund your lifestyle after retirement, an annuity can still be purchased at a later date, using whatever pension funds you have remaining. This means that you can decide to put off buying an annuity if rates are low, only to buy one later on at a better rate. With the requirement to buy an annuity by 75 being dropped, this will effectively give even more flexibility for those wishing to hedge their bets and bide their time.
Costs and Fees
Income Drawdown is not suitable for everyone, particularly if you have a smaller fund to invest. The capital that is not withdrawn does remain invested in protected investments, but as with all investments, yields can vary significantly on a yearly basis depending on the condition of the markets the funds are invested in. As such there is a higher risk than when purchasing an annuity. Additional charges and fees will be associated both with managing the funds and withdrawing regularly, so it is important that the pension funds are providing sufficient growth to cover these.
Down the Generations
Most significant, perhaps, is the fact that with an Income Drawdown, any funds remaining after you've died can be accessed by a surviving spouse or other dependents, whereas a traditional annuity will close after the death of the policy holder.
Your surviving relatives can choose from a number of options in this case, whether to continue to draw income or even buy an annuity. The entire remaining funds can be taken as a lump sum, although this is currently taxable at 35%, and soon to rise to 55%.
So while Income Drawdown may become an increasingly popular alternative to buying an annuity, the risks involved must be understood and it is important that you get advice from an independent financial advisor.

About the Author

John T Hughes is an expert financial writer with experience in the investment and retirement markets. John is resident writer at Independent Financial Advisor.co.uk, a site specialising in finding you expert advice on retirement products such as annuities.