What is a pension annuity and pension drawdown and how do they work?
Annuities and drawdowns are both popular options when it comes to taking your pension at retirement. Our guide explains what an annuity and drawdown are, how they work and which one could be right for you.
Key takeaways
A pension annuity is a way of converting your pension pot into an income for your retirement
A pension drawdown is where you leave money as an investment and only withdraw money when you need it
Both a pension annuity and pension drawdown are in addition to your state pension, which is based on your National Insurance contribution history and is separate from any of your private pensions
How do pension annuities work?
You use your pension pot to buy an annuity. The annuity amount you will get is based on many factors, including:
The size of your pension pot
The age that you retire
Your health
You can decide whether to receive a fixed amount each year – paid either monthly, quarterly, half-yearly or annually – or to have the annuity increase at a set rate or rise in line with inflation.
There are numerous annuity providers to choose from and you can compare rates with each before making your final decision.
What are the different types of pension annuities?
Annuity pensions come in a few different forms. These include:
Lifetime annuities
A standard annuity guarantees you an income for the rest of your life. A level annuity pays the same amount until you die, whereas an escalating annuity starts at a lower amount than a level annuity, but rises at a set rate or with inflation.
Enhanced annuity
Takes into account your health and lifestyle and could give you a higher income than a standard annuity. It can also be called an impaired life annuity, with the expectation that you receive a higher regular sum because you won’t live as long.
Fixed-term annuity
Provides you with a regular income for a fixed period, generally up to 25 years. At the end of the term, a guaranteed maturity value will be available that you can use to select another pension option.
What is an annuity rate?
An annuity rate, which is expressed as a percentage, is what determines how much annual income you’ll get from your annuity. Once you’ve bought your annuity, the agreed rate is locked in for the whole term – generally the rest of your life.
The rate you’ll receive depends on several factors, including your age when you buy the annuity, as well as your health, the amount you deposit and the options you select.
But perhaps the most critical determinant is interest rates. When interest rates go higher, you can usually expect annuity rates to rise with them.
Conversely, when interest rates are at sustained lows, annuity rates will generally fall too.
Why do annuity rates rise with interest rates?
Annuity rates generally rise when interest rates increase because annuity providers often invest in government bonds, which tend to offer higher returns when interest rates are higher.
When interest rates are low, the returns on these bonds are also lower, which can lead to lower annuity rates.
What are the advantages and disadvantages of pension annuities?
There are several benefits but some drawbacks to consider when choosing an annuity. These include:
Advantages
Having peace of mind of knowing what you’ll receive in pension income each year for the rest of your life
You can choose to fix your annuity or opt to have it linked to inflation (if you pick an inflation-linked annuity, it will typically start at a lower amount)
You can opt to have an agreed guaranteed minimum payment period. Useful if you want your annuity to continue to be paid to your dependants after your death
You can protect all or part of the amount of your pension pot used to buy the annuity – so that when you die a lump sum is paid to your dependents
You can choose monthly, quarterly, half-yearly or yearly annuity payment options
Disadvantages
Lack of flexibility – if your circumstances change you can't change your retirement income. For example, you can’t take a higher amount earlier in your retirement when most people need it or a lower amount once you can claim the state pension
Unless you choose a specific additional option, if you die the pension pot dies with you. Annuities are based on the average age you might die, so if you die earlier than this you receive less
Annuity rates can be relatively low so may not offer the best value for money
Whether you choose indexing (where payments increase over time, usually in line with inflation) or a fixed income, you may receive a significantly reduced amount once insurers factor in long-term cost increases
Find out more about how much pension you need to retire with our guide.
Is an annuity pension right for me?
Whether an annuity is right for you will depend on your individual circumstances and preferences, plus other factors including how attractive the annuity offer is. An annuity could be the right choice if:
You are eligible
You can only buy an annuity if you are aged 55 or over and have at least £5,000 available after you’ve taken any tax-free cash from your pension.
You value certainty
An annuity could be right for you if you want to know you’ll receive a stable income for the rest of your life that won’t be influenced by fluctuations in the stock market, for example.
You have poor health
If there is a greater risk that you will die relatively early due to health reasons, then you could receive an enhanced annuity that will give you a higher income.
You combine an annuity and drawdown
You can use some of your pension to purchase an annuity, leaving the rest invested and for drawdown. This option gives you some certainty and flexibility.
You delay until later in life
You can wait to purchase an annuity, giving you flexibility when you need it in early retirement and more certainty later in life.
If you’re still unsure whether an annuity is for you, Citizens Advice provides some helpful guidance on what you can do with your pension as you head towards retirement.
You can also work out how much income your pension might give you with our pensions calculator.
What is pension drawdown?
With drawdown, you leave your money invested and simply take money out of your pension as and when you need it.
The benefit of drawdown is that your remaining pension pot could benefit from growth even after you start taking money out. You also have control over how much you take out and when, either with regular income payments or in lump sums.
How does pension drawdown work?
Pension drawdown allows you to take money from your pension while keeping the rest invested. You can usually start from age 55 (rising to 57 in 2028), giving you flexible access to your savings.
You choose how and when to take income – monthly, quarterly, annually, or as lump sums – and you're in control of how much you withdraw.
You can take up to 25% of your pension tax-free, up to the current Lump Sum Allowance (LSA) of £268,275. The rest remains invested and may grow, but it’s also at risk of falling in value.
Unlike annuities, which often stop paying out when you die, drawdown pensions allow you to leave any remaining funds to your beneficiaries.
Pension drawdown became more flexible following the Pension Freedoms introduced in April 2015.
What are the advantages and disadvantages of pension drawdown?
Here are some of the reasons why pension drawdown might or might not be the best option for you:
Advantages
You could benefit from growth in the stock market, even when you start to take your pension
You have complete flexibility and can choose exactly what you drawdown, increasing or decreasing what you take at any time
Typically, annuities won’t pay out after your death. But with pension drawdown, you can pass your pension pot to loved ones as an inheritance
If you already have another defined benefit pension or source of income in retirement (i.e. a buy-to-let property), you may not need a fixed income from an annuity and may be better suited to flexible drawdown instead
Disadvantages
Your pension pot could run out if you withdraw too much or if your investments perform poorly, meaning you may not have enough income in later retirement
Your income isn’t guaranteed like with an annuity, so market fluctuations and poor investment returns could mean your pension doesn’t last as long as you need
Managing a drawdown pension requires regular monitoring and decision-making, which can be complex and time-consuming, especially if you’re not experienced with investments or financial planning
The value of your pension pot can fall due to investment risk, meaning you could end up with less money than expected when you need it most
What are my other options when I retire?
You don’t have to commit fully to an annuity or stick entirely to drawdown. You can choose to keep part of your pension pot invested while taking some as income.
One option is to use short-term annuities – fixed-term annuities lasting between one and twenty years – which provide a regular income while offering more flexibility than a lifetime annuity.
By combining this with drawdown, you can keep a portion of your pension invested, allowing for potential growth while still having access to income when needed.
Compare pensions with MoneySuperMarket
Having the right pension plan in place can be vital to make sure you and your loved ones are financially supported in your retirement – and the sooner you start the better.
MoneySuperMarket has partnered with MoneyFarm to help you make the most from your pension with a personalised pension plan. Using its hassle-free service, you can combine old pensions or set up new contributions easily online or through a dedicated pension adviser.
Not tied to anyone, MoneyFarm uses its impartiality and expert knowledge to choose the best funds from the whole of the market and make sure customers' pensions are always invested in the right place.
Capital at risk. This website does not constitute personal advice. If you are in doubt as to the suitability of an investment please contact your MoneyFarm dedicated adviser. MoneyFarm do not provide advice on or access to annuities.
MoneySuperMarket.com Ltd is an Introducer Appointed Representative of MoneyFarm, which is authorised and regulated by the Financial Conduct Authority. FCA number 596398. Registered in England & Wales, Company Number 07731925. Registered office address: Norwest Court, Guildhall Street, Preston, PR1 3NU.
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