Annuity or drawdown, set out without the sales pitch

At some point, anyone with a defined contribution pension, the kind built up as a pot, has to decide how to turn it into money to live on. Providers send thick packs. Advertisements promise “freedom”. Underneath the marketing there are really two basic tools, an annuity and drawdown, and the choice between them is about who carries which risk.

This article sets out how each works, what can go wrong, and the questions worth answering before choosing. It names no providers and recommends no product, because the right answer depends entirely on the person.

The starting point: a pot and a tax-free quarter

Whichever route is chosen, up to 25% of the pot can usually be taken tax-free, within an overall cap of £268,275. The rest is taxable income when it is paid out. We explain the different ways of taking the tax-free part in taking a quarter of a pension tax-free, and what happens to the rest. This article is about the remaining three quarters.

How an annuity works

An annuity is a contract with an insurer. The saver hands over some or all of the pot, and in return the insurer pays a fixed income for an agreed period, most commonly for the rest of their life. The insurer takes on two risks the saver would otherwise carry: that investments fall, and that the saver lives much longer than expected.

The details are chosen at the outset and usually cannot be changed afterwards:

• Single or joint life. A joint-life annuity continues paying, often at a reduced rate, to a husband, wife or partner after the first death.
• Level or increasing. A level annuity pays the same amount for life; an increasing one starts lower and rises each year, either by a fixed percentage or with inflation.
• Guarantee period or value protection. These options pay something to an estate if the annuitant dies early.
• Enhanced annuities. People with certain health conditions or lifestyle factors may be offered a higher income because their life expectancy is assessed as shorter.

Annuity rates differ between insurers, and the existing pension provider is not obliged to offer the best one. Comparing quotes from across the market, rather than accepting the first offer, is one of the few things all official guidance agrees on.

How drawdown works

With flexi-access drawdown, the pot stays invested. The owner takes the tax-free part at the start, if they wish, and then draws taxable income whenever they choose, in whatever amounts they choose. What remains can go up or down with the investments.

That flexibility is the attraction: income can be adjusted, paused or taken as one-off sums, and what is left can pass to family on death. It is also the risk. Money taken out cannot be put back, a run of poor returns early on can do lasting damage, and nobody knows how long they will live. Once taxable income is drawn, the amount that can be paid into defined contribution pensions with tax relief usually falls to £10,000 a year.

A general comparison of features. Terms, charges and options vary between products and providers.

An annuity buys certainty and gives up flexibility. Drawdown keeps flexibility and gives up certainty. Neither is free.

Combining the two

The choice is not all or nothing. Some people use part of a pot to buy an annuity that, together with the State Pension, covers essential bills, and keep the rest in drawdown for occasional spending. Others start in drawdown and buy an annuity later, when rates for older buyers are typically higher. The State Pension itself already behaves rather like an inflation-linked annuity, which is worth counting before deciding how much more guaranteed income is needed. Its current rates and how they rise are set out in how the triple lock decides each April’s increase.

Tax, and what passes on

Annuity income and drawdown withdrawals are both taxed as income. A first drawdown withdrawal is often taxed on an emergency basis, as explained in why a first pension withdrawal is often taxed too much.

The government has also confirmed that unused pension funds and death benefits will be brought into the scope of inheritance tax from 6 April 2027. That affects how much of a drawdown pot left on death may eventually reach family, and is a further reason to take guidance specific to the estate concerned.

Questions worth answering first

• What income is needed each month for essentials, and how much of that do the State Pension and any defined benefit pensions already cover?
• Is there a partner who would need income to continue after a death?
• How comfortable is the household with income that could fall, or a pot that could run low in later life?
• Are there health conditions that could mean a higher, enhanced annuity?
• Will anyone have the time and confidence to review drawdown investments for years to come?

Where to get free, impartial help

Pension Wise, a service from the government-backed MoneyHelper, offers free guidance appointments to people aged 50 or over with a defined contribution pension. It explains the options but does not tell anyone what to do. A regulated financial adviser can give a personal recommendation, usually for a fee. The Financial Conduct Authority register shows whether a firm is authorised. Anyone who cold-calls offering a pension review should be treated with caution.

Who this matters for

• Anyone with a defined contribution pot approaching the age at which they plan to use it.
• Anyone who has found an old pot and is deciding what to do with it. See tracking down a pension from a job you left years ago.
• Couples, because single-life and joint-life choices affect the survivor.

The takeaway

An annuity and drawdown solve different problems. An annuity removes uncertainty at the cost of flexibility; drawdown keeps flexibility at the cost of uncertainty. Many people end up with a mix. The useful first step is to work out how much guaranteed income is really needed, and to take the free Pension Wise appointment before signing anything.