Pensions: annuity or drawdown? Here's what you need to know to plan for retirement

Annuity or drawdown will be the key words once you reach age 55 and allowed to access the money in your pension pot.

Pension drawdown (also known as income drawdown or flexi-access drawdown) allows you to take cash out as you please. An annuity, on the other hand, pays a fixed income for the rest of your life in exchange for your pension.

The age at which you can take money out of your pension will rise from 55 to 57 from 2028, regardless of whether you buy an annuity or use drawdown.

Both options have their own advantages and risks, and it’s vital you weigh them up before making a choice. It’s especially important that you think carefully before buying an annuity, as it’s an irreversible decision. 

To help you decide how to access your nest egg, we explain how drawdown and annuities work.

Annuity or drawdown: What is pension drawdown?

Drawdown allows you to take out as much money as you like, as often as you like. You leave the rest of your pension savings invested - and choose how they are invested - and either set up regular withdrawals, or take out money ad-hoc. 

Ideally, your investments will do well, your pension will get bigger and it will last the rest of your life. However, there is no guarantee this will happen. There is a risk your investments will fall in value, or you withdraw too much cash - or both - and you run out of money during retirement. 

Note that drawdown is only possible if you have a defined contribution pension such as a modern workplace scheme or self-invested personal pension (SIPP). If you have a defined benefit scheme, such as a final salary pension, you won’t be able to use drawdown - unless you transfer it to a SIPP first.

How does pension drawdown work? 

Your pension provider may offer a drawdown service, so speak to them about your options. 

However, just like buying travel insurance or choosing an energy supplier, it’s important to compare different drawdown services, so make sure you also shop around.

Sticking with your pension provider may be easier but switching to a different pension company or an online investment supermarket could save you money, offer more flexibility and provide more investment choice.

Once you’ve transferred your pension into drawdown, you can choose to:

1. Leave the money where it is
2. Cash it all in
3. Take a regular income
4. Withdraw lump sums as and when you like

You can usually take 25% of your pension tax-free (the rest is liable for income tax). Depending on the type of drawdown scheme you choose, there are several ways to do this. 

One option is to take your tax-free cash as a lump sum - this is known as a pension commencement lump sum (PCLS) - before taking withdrawals that are subject to tax. 

Another option is to take uncrystallised funds pension lump sums (known as UFPLS). This is where each withdrawal is 25% tax-free.

It can be tricky working out how much to withdraw, especially when you don’t know how your investments will perform, or how long you’ll live.

One rule of thumb to preserve your pension savings is to take around 4% of your fund as income in your first year, and then increase that amount by inflation in each future year.

Becky O’Connor, head of savings and pensions at interactive investor, gives an example. “Taking 4% of a £300,000 pot would have a sustainable drawdown rate of about £12,000 a year. Leaving your pension invested has the benefit that what’s left can continue to grow.”

Another option is to stick to withdrawing the “natural yield”, which is the dividends and income produced by your investments, without touching the actual pension pot. That way, you have the pension pot to fall back on if the income falls and/or you need extra money, or if you’d like to leave the pot of money as an inheritance.

Pros of drawdown

Flexibility: Drawdown allows you to take less income if you are still working or take higher payments until your state pension becomes available.

Freedom: You are in charge and can take as much or as little as you want. You are not limited to a set amount as you would be with an annuity.

Investment growth: Your pension stays invested so could rise in value. Investment growth could outstrip inflation, giving you more purchasing power in the future.

Avoid inheritance tax: If anything is left in your pension when you die, you can leave it to your loved ones free from inheritance tax.

Cons of drawdown

Risk 1: if you take out too much, too soon, your pension could shrink quickly and leave you with nothing.

Risk 2: Your pension is still invested so at the mercy of any dramatic stock market falls.

Effort and responsibility: Taking income this way is a juggling act as you have to balance what you need to be comfortable with keeping enough for future expenses. Unless an adviser manages it, you have to monitor investment performance and manage withdrawals.

What is an annuity?

With an annuity you give your entire pension pot to an insurance company and in return they pay you a guaranteed income for life. Savers typically take their 25% tax-free cash as a lump sum before using the rest to buy an annuity.

The rate of income the insurer pays is determined by things like interest rates, competition among insurers and your life expectancy.

Annuities called “enhanced” or “impaired life” pay a higher rate if you are expected to have a shorter life expectancy. For example, if you are a smoker or suffer from a medical condition that may shorten your life such as diabetes, high blood pressure or heart disease.

Pros of pension annuities

Peace of mind: You get a guaranteed, regular income for life whatever happens in the stock market.

Little admin: You make just one decision and then it’s done.

Value in very old age: If you live until your 90s or past 100, an annuity will give you more than your original pension pot - and possibly more compared to drawdown.

Inflation boost: If you are happy to start with a lower income you could choose an annuity that rises each year with inflation.

Security for a spouse: A joint annuity will pay your spouse or civil partner an income if you die first.

Higher payments for health issues: You receive a higher rate if you have a shorter life expectancy due to an underlying health condition.

Cons of pension annuities

Low rates: Annuity rates are very low compared to a decade ago, due to the rock-bottom interest rate, so can seem bad value.

No refund: You cannot change your mind later or negotiate the amount you receive.

Risk: If you pass away shortly after you take out a single-life annuity, the insurer will swallow the rest of the money in your pension, leaving nothing for loved ones.

Which is better: annuities or drawdown?

There is no correct answer to this question; it really is a personal choice. However, one thing’s for sure: annuity sales have fallen sharply since 2014, when George Osborne famously declared that “no one will have to buy an annuity” and relaxed the drawdown rules. And annuity rates have dropped too.

Becky O’Connor at interactive investor notes: “Since the financial crisis and a steep drop in interest rates over the past 13 years, annuity rates have fallen, making them relatively poor value. Nowadays, you still get the security of knowing you have an income for life with an annuity, but you don’t get as much income each year as people used to. So, they have become a lot less popular.”

If you’re seeking a predictable, regular income in retirement, and don’t want the hassle of managing your pension for the rest of your life, an annuity could be the right choice. 

Ditto if you’re convinced you will live to 100 like your dad, and his dad before him, then you may like to consider an annuity. If you have a health condition that qualifies you for a higher rate, an annuity may be worth considering too.

However, if you’re the sort of person who wants the freedom to withdraw their money as they please, or is turned off by the poor annuity rates on offer, drawdown could be a wise choice.

Drawdown could make sense if you already have a reliable income coming in from elsewhere, such as a rental property, part-time work or final salary pension.

Look at your finances and lifestyle as a whole, remember there's income tax and be realistic about your needs in later life before deciding which to go for. 

Also bear in mind you don’t need to decide as soon as you hit age 55. If you initially decide to do drawdown, you can reassess your options later, say at age 70, and potentially buy an annuity with your remaining pot if you’ve decided you do want a regular, guaranteed income after all.

Taking advice about your pension

To help you decide which approach to take you may want to speak to a financial adviser. You can find a financial planner at unbiased.co.uk or VouchedFor.co.uk. An adviser can help you decide if drawdown is right for you, figure out which investments and provider to choose and the level of income to take. You will typically pay a fixed fee depending on the work, or a fee as a percentage of your pension pot - especially if you’d like to receive ongoing advice.

If you’re looking for more general help, you can book a free appointment from age 50 with the government service Pension Wise. However, Pension Wise will not tell you which approach to take regarding drawdown or which investments to choose.

READ MORE: Naomi consolidated her pensions and overhauled her later life finances.