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 whether it could be right for you. 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.
What is a pension annuity?
An annuity is a way of converting the pension pot you have built up through your career into an income for the rest of your life.
The main benefit of a pension annuity is that the income is guaranteed. So you’ll know exactly how much you’ll receive as retirement income and can budget accordingly.
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 pension pot remains invested and 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 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 and your health. These factors determine how much of an annuity you might be able to get.
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.
How does pension drawdown work?
Before April 2015 pension drawdown rules were very restrictive. Pension Freedoms legislation was introduced in 2015 giving individuals more choice over what to do with their pension savings and how they want to access their pension when they retire. Flexible access drawdown was introduced in 2015. When you reach 55 years old (rising to 57 in 2028) you can start pension drawdown, by taking money out of your pension.
You have complete control over when and how you choose to take your pension, including monthly, quarterly, annually or in lump sums. You can set up regular withdrawals or ask your pension provider to send you a payment.
Unlike most annuities that stop when you die, these flexible pensions allow you to pass on your remaining pension pot as an inheritance for your next of kin. (Note, there are some annuities that you can purchase which will continue to provide an income for your chosen beneficiaries until their death or you can build in value protection to your annuity which means for example if you paid £50k for an annuity but only got £30k back before you died then the remaining £20k could be paid to a beneficiary. These annuity options would reduce the income level of the annuity).
Both options allow you to take 25% tax-free from your pension in one go, but with drawdown, you can also do it bit by bit, whatever works for you.
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 rate you receive 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.
What are the benefits of pension annuities?
There are several benefits to choosing an annuity. These include:
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
Find out more about how much pension you need to retire with our guide.
What are the disadvantages of pension annuities?
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
The options of indexing or a fixed sum at maturity significantly reduce the income you could receive
What are the benefits of pension drawdown?
An annuity isn’t right for everyone. Here are some of the reasons why pension drawdown might be the best option for you:
You could benefit from potential 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.
What are my other options when I retire?
You’re not obliged to buy an annuity as your sole income in retirement. You can also choose to leave a portion of your pension pot invested in your provider’s investment fund and take some of it as income.
If you decide this is what you’d prefer to do, you can opt for...
Pension income drawdown – This allows you to withdraw money from your pension pot as income. The sum that remains invested can then potentially grow, in line with your pension fund’s performance
Buy short-term annuities – You can also opt to buy a series of fixed-term annuities, which last between one year and twenty years. These are more flexible than regular annuities, while still giving you a regular income
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
Use 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.
Purchase an annuity 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
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