21 JAN 2025
What is pension drawdown and how does it compare with an annuity?
By IFGL Pensions Technical Services Manager Steve Berridge
When you approach your retirement, you’ll have to make some important decisions about how you choose to access your pension. There are two main ways you can do this, through a drawdown process or by buying an annuity. Both have advantages and disadvantages and which is best for you will depend on your circumstances and plans for your retirement.
You can also opt to split your retirement savings between more than one option – for example use part of your savings to buy an annuity to guarantee a certain amount of income, leaving the rest of your money in more flexible drawdown.
Drawdown can be a popular choice for people who want to take money out of their pension in a variable way (different amounts each year). It is only available for those with defined contribution pensions (e.g. personal pensions/SIPPs and the majority of the private sector workplace pension schemes).
When you reach the age you want to start drawing on your pension (you must be at least age 55, or age 57 from April 2028) you keep your pension invested, but are free to take withdrawals, known as income payments, as little or often as you want.
The main attraction is that you are not tied into regular withdrawals, but it’s your responsibility to manage the withdrawals so that your savings are not depleted too soon.
Drawdown is a good option if…..
- You’re happy to keep your pension monies invested.
- You don’t necessarily want a fixed regular income, and want to retain the option to choose when to withdraw.
- You want to vary the amount you receive each year.
- You are ‘phasing’ retirement, for example by reducing your working hours, and therefore only need to supplement your working income by a small amount at first.
- You are retiring before your state pension age, and therefore might want to draw more income out of your pension in the early years, reducing your withdrawals once your state pension kicks in.
- You don’t want to make lots of ‘once in a lifetime’ decisions at the point of retirement, i.e. whether to build in spouses pensions, or whether to build in guarantee periods.
- You might want to buy an annuity later, with any money left within your drawdown pot.
Drawdown is not a good option if….
- You want a guaranteed income in your retirement.
- You are concerned that you might run out of money.
- You are worried about the risk of your pension fund remaining invested.
- You want to keep saving into pension in the future, and may want to make sizeable contributions (as soon as you start to draw income from your pension, you trigger a strict limit around future tax efficient pension saving called the Money Purchase Annual Allowance, or MPAA. This is currently £10,000 per annum.) Those thinking about accessing pensions at a young age, in their late 50’s or early 60’s need to be especially careful to consider this point.
- You don’t want to actively manage your pension savings in retirement, continuing to make investment and income decisions.
What about tax and charges on my drawdown money?
- Most providers will charge an annual fee both for administering your pension and making any income payments.
- The first 25% of your pension fund is usually available as a tax-free lump sum.
- The income tax charged on your income will depend on the amount you withdraw and any other income payments you receive. It will normally be 20% for a basic rate tax payer, 40% for a higher rate tax payer and 45% for an additional rate tax payer.
What if I die?
- If you die before age 75, your beneficiaries can inherit your drawdown pension and will receive income payments tax-free.
- If you die after age 75, under current rules your beneficiaries can still inherit your drawdown pension but will be taxed on withdrawals at their marginal rate.
It is worth noting that a consultation is currently underway following an announcement in the October 2024 Budget that pensions will fall into the scope of Inheritance Tax from 2027.
What about an annuity? How does that work?
The annuity was the original choice available to people when their pensions reached their chosen retirement age, or they decided to start drawing from them. In fact for many years it was the only option, and it’s what comes to mind when you think of a pension: a regular payment that continues throughout your retirement, no matter how long you live for.
When you buy an annuity, you swap all or some of your savings for a policy from an insurance company, which provides a guaranteed income for the rest of your life. Again, purchasing an annuity is only available from age 55 (or age 57 from April 2028).
Annuities were a popular choice for years, but when interest rates reduced significantly in the 2000s, their popularity waned because the amount of income you receive is linked to the prevailing level of interest rates at the time you buy your annuity, amongst an array of other factors.
Recently, annuities have fallen back into favour, with annuity rates (the amount of annual pension income you can expect per £1 of pension fund savings) increasing, and individuals reaching retirement finding a safe and secure option quite appealing.
An annuity is a good option if….
- You want the security and certainty of a regular income payment for life.
- You don’t want the risk of your pension fund remaining invested after you retire, or the ongoing requirement to continue to monitor your investment choices and make changes.
- You aren’t likely to need regular ad-hoc large sums in your retirement, or wish to vary your income substantially
- Interest rates are high and this means that annuity rates on offer are favourable.
- You are in good health, and don’t want to run out of money if your retirement is a long time (more people are living to and through 100 than ever before, which might mean a retirement as long as your working life!)
An annuity is not a good option if…….
- You don’t want to be locked into a regular income payment that cannot be changed.
- Your circumstances mean you might need occasional large lump sums.
- You want the freedom to stop and start your income payments.
- Interest rates are low meaning the annuity rates on offer are unfavourable.
- Your personal circumstances are likely to change, and you don’t want to make important decisions about the shape of your annuity at the point of purchase (for example whether to provide a spouse’s or beneficiary pension, or index linking, which can only be added at outset).
What about tax and charges?
- The annuity payment offered by the insurance company can vary significantly between different annuity providers. Hence it is worth shopping around for the annuity which provides the best income for you, just like you would when making any other insurance based purchase (your house or car insurance for example). The difference between the ‘best’ and ‘worst’ rates can be significant, and as this is a ‘once in a lifetime’ purchase, this is the most important shop-around you’ll ever do.