What is the difference between an annuity and pension drawdown?

If you are thinking of taking an income from your pension then you have two main options: one offers greater security while the other gives you the freedom to take money as and when you like.

The quick and easy guide to annuities and pension drawdown

If you want to know more about annuities and pension drawdown then this guide is for you. It explains the key features of each option and the differences between the two, plus a quick look at which choice could be right for you.

Headline facts at a glance

People generally save into a pension so that they have money to live off in the future, usually when they retire. If you don’t have a company pension that is promising to pay you a generous guaranteed income for life then you probably have two main options when it comes to accessing your pension money.

You could buy what is called an annuity. This will give you the security of a guaranteed, regular income for life; the amount of money you will receive depends on a number of factors. The main alternative is to go into what is known as pension drawdown. With this option you have the freedom to take as much or as little money from your pension as and when you like.

Each option has pros and cons and the one that is right for you depends very much on your circumstances, outlook and future plans. Before we consider the key differences between these two options let’s look at each in a bit more detail.
 


What is an annuity?

To buy an annuity you sell your pension pot to an insurance company which then promises to pay you a guaranteed, regular income for life. You can take your 25% tax-free lump sum from your pot before you do this and the amount of income you receive each year is a percentage of the value of your pot when you sell it. This percentage (also known as the annuity rate) depends on a number of factors including your age, the yield of British government bonds and the type of annuity that you decide to buy:

 

  • A standard annuity: You get a guaranteed income for life. A number of years ago the annuity rate was as high as 10% of the value of your pot when sold it. So, if you had a £100,000 pension you would get £10,000 a year for the rest of your life. These days, annuity rates are around 4% for 55-year-olds and with a standard annuity this income stops the day you die.
  • An enhanced annuity: If you have certain health conditions you could get a higher annuity rate which means more money per year for you. This type of enhanced annuity could also be available for you depending on your weight or lifestyle choices, such as how much you smoke or drink.
  • An escalating annuity: With this type of annuity you can choose for your annual income to increase in line with inflation, or by a set percentage. To cover the cost of this escalation the income you initially receive will generally be lower than if you had purchased a standard annuity.
  • A fixed-term annuity: Generally, once you buy an annuity your decision is final; you cannot change your mind and choose another pension option further down the line. This is not the case with a fixed-term annuity. This type of product allows you to use some or all of your pot to secure a guaranteed, yearly income for a set number of years - often five or ten - as well as what is called a maturity amount: a lump sum payable to you at the end of the fixed-term period. With this option you have the freedom to see how an annuity works for you for a number of years without having to commit to one for life.

You can buy an annuity from the age of 55.

What is pension drawdown?

From the age of 55 you can start to take money from all private pensions and many types of company schemes. You can take your money as and when you like, with the first 25% being tax free. So, you could choose to take a sensible, regular income with the aim of making your pot last for the rest of your life. Alternatively, you could take your whole pot in one go, although this could leave you with a hefty tax bill and no money to live off when you retire.

With pension drawdown you can pass on any money left in your pot when you die to whoever you choose.

What are the main differences between an annuity and pension drawdown?

Keeping ownership of your pension

If you buy an annuity then you no longer own your pot, if you opt for pension drawdown then you do. By owning your pot and keeping it invested there is potential for it to grow and therefore you could have more money that you had planned for in your retirement. On the flip side, if stock markets perform badly then you could be left with less money than you had hoped for.

An annuity offers security rather than this potential to balance risk and reward. Annuities are not completely risk-free, though. Current annuity rates are much lower than they were a few years ago and generally the income you receive will decrease in real terms over time because of the effects of inflation.

The flexibility to vary your income

With pension drawdown you can vary the amount of money you take from your pot as and when you like. This gives you the flexibility to adapt to changes in your life, although you need to be careful not to take too much too early and run out of money. If you have bought an annuity then you cannot choose to vary the income you receive, the amount is set depending on what type of product you have purchased.

Receive a guaranteed income for life

If you buy an annuity then an insurance company is promising to pay you a guaranteed amount of money each year for the rest of your life. With pension drawdown there are no such guarantees. The good news is there are new products that can offer you some of the flexibility of drawdown with the security of a guaranteed income for life.  

Leaving a legacy to your family

With an annuity you cannot pass on any money to your family when you die, unless you buy a joint-life or certain type of guaranteed product. Even then your options are limited compared to pension drawdown which lets you leave any remaining money in your pot to whoever you choose when you die.

Can I buy an annuity or opt for drawdown with any type of pension?

If you have what is known as a defined benefit scheme, often called a final salary pension, then in most cases you would first need to switch to a modern private pension. Depending on the scheme you have this might not be the best option for you because you could be giving up great benefits, including a guaranteed income for life. And if you have what is known as an unfunded pension scheme then at the moment you cannot buy an annuity or opt for pension drawdown. This type of scheme can cover a number of public sector professions and jobs including the NHS, the armed forces, the emergency services and teachers.

An annuity or pension drawdown: which option is right for you?

Are you looking for security or flexibility? Are you prepared to take a risk for potentially more reward? Or, is safety-first the only way? The right pension option for you depends very much on your current circumstances, your outlook and your future plans. New products on the market and new freedoms around what you can do with your pot means that you have more options than ever before when it comes to your pension. That is why it is so important to speak with an expert before you make a decision. We have already helped more than 14,000 people to get the most out of their pension and it would make us very happy to help you to do the same.


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More information...

Hopefully the information in this guide has given you a clear idea about what an annuity and pension drawdown are and the key differences between the two options. We have included below answers to a few more questions we are regularly asked and if you cannot find what you are looking for here then why not give us a call.

Can I buy an annuity and go into pension drawdown?

You certainly can mix and match. You may want to use some of your pot to buy an annuity and secure a guaranteed income for life while using your remaining savings to drawdown money flexibly, as and when you need it.

Can annuity rates go up and down?

They can. The annuity rate is very closely linked to what are known as gilt rates which can vary over a short space of time. Annuity rates are currently much lower than they were a few years ago and it is vital to shop around because what different annuity providers are offering can vary wildly.

What happens if the stock markets crash?

If you buy an annuity then generally you do not need to worry about stock market crashes; you no longer own your pension pot and have been promised a guaranteed income for life. If you go into pension drawdown then your savings are still invested, with a proportion usually in stocks markets. So, there is a danger that a drop in the stock markets could have a significant impact on your pension pot. This works both ways. So, if stock markets go up then so could the amount of money you have to live on in the future.

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Important information

A quick reminder that the tax you pay depends very much on the current rules and your personal circumstances, and so could change in the future.

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