Pension Drawdown vs Annuity: Which Is Best?

Option one

What is an annuity?

An annuity is an insurance product. You hand over some or all of your pension pot and in return an insurer pays you an income, either for the rest of your life or for a fixed number of years.

The appeal is certainty. A lifetime annuity pays for as long as you live, however long that turns out to be, and you never have to think about investment markets again. The trade off is that the decision is generally permanent, and once you have bought it, that money is no longer yours to spend differently.

There are several choices to make when you buy one, and they change the income you get:

• Level or rising. A level annuity starts higher but its buying power shrinks with inflation. A rising one starts lower and increases each year.
• Single or joint life. A joint life annuity carries on paying a partner after you die, for a lower starting income.
• Guarantee period. Keeps paying for a set number of years even if you die early.
• Enhanced. Certain health conditions and lifestyle factors can mean a higher income, because the insurer expects to pay for fewer years. It is worth disclosing them fully.
• Fixed term. Pays for a set number of years rather than life, sometimes with a lump sum at the end.

How much income you get depends on your age, your health, the options above, and interest rates at the time you buy. Rates change, so a quote is only good for a short period. Shopping around matters: the annuity offered by your own pension provider is not necessarily the best one available.

Option two

What is pension drawdown?

With flexi-access drawdown, your pension stays invested and you take money out as and when you choose. Usually up to a quarter can be taken tax free. The rest provides taxable income, which you can take regularly, occasionally, or not at all.

The appeal is control. You can take more in the years you need it and less in the years you do not, and what is left keeps the chance to grow. The trade off is that the risk stays with you. Nothing guarantees the income, and if you withdraw too much, or markets fall badly early on, the money can run out while you still need it.

That second point has a name, sequence risk. Taking income from a pot that has just fallen in value means selling more of it to raise the same amount, and a pot depleted early can struggle to recover. Drawdown needs a withdrawal level you can sustain and a regular review, not a set and forget approach.

The decision

Which is better, drawdown or an annuity?

It depends on your circumstances, and anyone who answers without asking about them is guessing. These are some of the questions that matter most.

Mixing them

Can you combine drawdown and an annuity?

Yes, you can use both. One approach is to use part of the pot to buy an annuity that, together with the State Pension, covers essential spending, and keep the rest in drawdown for flexibility and anything unexpected.

Another is to start in drawdown and buy an annuity later. Annuity rates are usually higher the older you are, and later in life many people value simplicity more than flexibility. You can use some or all of a drawdown pot to buy an annuity at any point.

If your pensions are spread across several old schemes, it may be worth looking at them together before choosing, and our guide to combining old pensions covers what to check first.

The order matters because the move the other way is generally closed. Once a lifetime annuity is in place, it cannot usually be cashed in or switched back into drawdown after any cancellation period ends.

Tax

How are drawdown and annuities taxed?

The income is taxed the same way whichever route you choose. Annuity income and drawdown income are both added to your other income, including the State Pension, and taxed at your normal rate.

Usually up to 25 per cent of a pension can be taken tax free, subject to the lump sum allowance. You can take it all at once or in stages, and how you do it can affect how much tax you pay over your retirement.

Drawing large amounts in a single tax year can also push you into a higher rate band. Spreading withdrawals is often more efficient, which is one of drawdown's genuine advantages over taking a pot as cash. For more on this, see how pensions are taxed in retirement.

Your estate

What happens when you die?

This is where the two differ most, and where the rules are about to change.

With drawdown, what is left in the pot can usually pass to the people you nominate. With an annuity, it depends on the options you chose. A single life annuity with no guarantee stops when you die. A joint life annuity carries on paying your partner, and a guarantee period keeps it going for a set time.

Income tax depends on your age when you die. According to GOV.UK, if you die before 75, most death benefits from a defined contribution pension are paid free of income tax, subject to limits and a two year time condition. If you die at 75 or over, your beneficiaries pay income tax on what they receive at their own rate.

Inheritance tax

Will pensions be subject to inheritance tax?

From 6 April 2027, yes, in most cases. GOV.UK confirms that for deaths on or after that date, most unused pension funds and pension death benefits will be included in the value of an estate for inheritance tax. Death in service benefits and dependants' scheme pensions from defined benefit arrangements are excluded. Personal representatives will be responsible for reporting and paying any tax due.

For some families this is a significant change. Drawdown has often been used partly as a way to pass money on outside the estate. After April 2027, money left in a pension may face inheritance tax, and if you die at 75 or over, income tax as well when your beneficiaries draw it. Whether that matters depends on the size of your estate against the inheritance tax threshold, but it is worth reviewing any plan built around leaving a pension untouched.

Risk

Is pension drawdown safe?

Drawdown is regulated and widely used, but it is not risk free, and it is not meant to be. The pot is invested, so it can fall as well as rise.

The main risks are taking too much too soon, a market fall early in retirement, and living longer than the money lasts. None of those is a reason to avoid drawdown. They are reasons to set a withdrawal level you can sustain, hold investments suited to taking an income, and review both at least once a year.

Protection if a firm fails also differs. The FSCS covers annuities at 100 per cent with no upper limit where it can pay compensation. Money in drawdown is protected according to the product and the reason for the failure, and some investment claims are limited to £85,000 per person per firm.

What people choose

How many people choose drawdown or an annuity?

Drawdown is still chosen far more often than an annuity, but annuity purchases rose again. Higher interest rates in recent years have made annuities more attractive than they were a decade ago, which is one reason to get a fresh quote rather than relying on old assumptions.

The other figure worth noticing is that almost half of pots were cashed in completely. Taking a whole pot as cash can mean a large tax bill in one year and nothing left for later. It suits some small pots, but it is a decision to make deliberately.

Advice

Do you need advice to decide?

Not always. Pension Wise, from MoneyHelper, offers a free, impartial guidance appointment to anyone 50 or over with a defined contribution pension. It explains your options and how they are usually taxed. It is guidance, not advice: it will not recommend what you should do. For a small pot and straightforward circumstances, that may be all you need.

Paid advice may be particularly useful where the pot is large, you have several pensions, you are weighing an annuity against drawdown for a partner as well as yourself, or inheritance tax is a concern. It is also worth considering because an annuity decision is so hard to reverse. If you want to know what advice costs before you decide, see our guide to financial adviser fees.

Common questions

Drawdown and annuity questions, answered

This guide is general information only. It is not personal financial advice or tax advice, and it does not take account of your circumstances. The value of investments, including pensions in drawdown, can fall as well as rise and you may get back less than you invested. Income from drawdown is not guaranteed and may not be sustainable. A lifetime annuity is generally irreversible once any cancellation period has ended. Tax treatment depends on individual circumstances and may change in future. The inheritance tax treatment of pensions described here applies to deaths on or after 6 April 2027.

Every Step Financial Services is an Appointed Representative of New Leaf Distribution Ltd, which is authorised and regulated by the Financial Conduct Authority, FRN 460421.