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This choice has been around for everyone since the 'pension freedoms' were introduced in 2015. The rule changes gave people much more flexibility over how they use their defined contribution pension savings.
That means you've got more control over how you take your money. But it also means there's more to think about when it comes to choosing the right approach for you. In this guide, we’ll walk you through your options so you can feel more confident about your next steps.
Accessing your pension pot
You can access your pension at any point from age 55 (rising to 57 from April 2028). You can withdraw up to 25% of your pension pot tax-free. Any income you receive after the tax-free lump sum is taxed as earnings at your marginal rate.
Once you take your tax-free lump sum, you can use your remaining money to set up one or more retirement income options. Let’s take a look at how they work.
Annuities
An annuity is a financial product that converts your pension savings into regular guaranteed income, either for the rest of your life (lifetime annuity) or for a fixed number of years (fixed-term annuity).
The amount of income you receive depends on several factors, including the size of your pension pot, your age and current annuity rates at the time of purchase. You may also be eligible for more income with an enhanced annuity if you have certain health issues or have made certain lifestyle choices, such as smoking.
The main benefit of annuities is that they provide a fixed income that you can rely on. Your income won’t be affected by investment ups and downs. Also, because of this certainty, an annuity requires little or no management or oversight. That makes it potentially a good choice if you just want to set something up that pays your income with no need to worry about managing invested money.
On the flipside, an annuity is less flexible than drawdown. Once purchased, the annuity can’t usually be changed, so you need to be certain about your choice.
Also, there is the risk that if you die early, you won’t have benefitted from the full value of your pension savings. However, it is possible to include death benefits in an annuity so that someone you care about receives a lump sum or income after you pass away. However, these need to be selected at the outset and cannot be added to your annuity once it is set up.
Income drawdown
Income drawdown, or flexi-access drawdown, allows you to keep your pension savings invested while withdrawing income as needed. After taking the tax-free portion of your pot, the rest remains invested and accessible for future withdrawals.
It is typically more flexible than an annuity as you have control over how much you withdraw and when. Also, as your pension fund remains invested, it could increase substantially in value if markets perform well.
However, with that potential for growth comes the risk that - unlike annuities - you may lose money if investments perform badly. There is also the risk that if you withdraw too much too quickly, or if markets fall, your pot could shrink faster than expected.
Because of this investment element, your income is not guaranteed with income drawdown. You (or your adviser) must therefore monitor your investments and income regularly.
We mentioned above that you can choose to include death benefits in an annuity. But with income drawdown, it’s an automatic feature that any money still in your fund when you die can be passed to your beneficiaries, subject to inheritance tax rules.
Comparing annuities and income drawdown
The biggest distinction between these two options lies in investment exposure and income security:
Annuities offer income security and predictability: You’ll know exactly how much you’ll receive each month, which is particularly useful for covering essential living costs. But there’s no chance to benefit from market growth once the annuity is in place, so you will be relying on the set income for the rest of your life or for a fixed term.
Drawdown offers the potential for investment growth: If markets perform well, you could see your pension savings grow considerably. But your income is not guaranteed, and you’ll need to be comfortable accepting some level of investment risk - and take care not to withdraw too much too soon. If markets underperform, or if you live longer than expected, you could face a shortfall later in retirement.
Another point of difference is in terms of flexibility vs certainty:
Flexibility is a strong advantage of drawdown: You can vary your income over time, and take no income at all for periods if you wish. Also, you can use some of your money within the drawdown fund to buy an annuity later on if you do decide to switch to a guaranteed income.
Annuities are less flexible: Once purchased, you generally can’t alter the income amount or switch products. That said, a fixed-term annuity offers some middle ground. You can set it up so that you receive a guaranteed lump sum at the end of the term, giving you the option to reassess your strategy later.
The two options also differ when it comes to death benefits:
With drawdown, death benefits are automatic: Any funds left in your pension can be passed to beneficiaries, potentially free of tax depending on your age at death.
Annuities offer this option if you specifically choose it when you set up your annuity: You have a few options for how to set up your death benefits, for example to pay either a lump sum or income, and the term of income if you choose that option. Adding death benefits to your annuity will typically reduce your regular income but provides peace of mind that your loved ones will benefit.
Regardless of which option you choose, income from your pension may affect your eligibility for means-tested benefits like Pension Credit or Housing Benefit. Also, remember that you will be liable for income tax at your marginal rate in income over your personal allowance, once you have taken your 25% tax-free allowance.
What about fees?
Annuities and income drawdown also differ when it comes to fees:
Annuities: Annuity providers charge for their service, but their fees are typically reflected in the annuity rate, so there won’t usually be any ongoing management fees once your annuity is set up. You may also pay advice or broker fees, although with Compare More’s selected annuity brokers there is nothing to pay as their commission from the provider is taken into account when calculating the annuity rate.
Drawdown: Providers typically charge annual service fees for managing your investment fund, and some also charge set-up fees, annual administration fees and additional withdrawal fees. You may also incur charges for ongoing financial advice from your provider or financial adviser.
Other income options
Annuities and income drawdown aren’t the only options for taking income from your defined contribution pension savings. The third main option is known as lump sum withdrawals.
This is when you leave your pension savings in your pension scheme and take money as and when you need it (sometimes paying a small charge to do so) until your money runs out or you choose another option. This is also known as Uncrystallised Funds Pension Lump Sum (UFPLS).
Each time you take a lump sum, 25% is usually tax-free. The rest is added to your other income and is taxable at your marginal rate. Money that remains in your pension pot stays invested, so the value of your pension pot can go up and down depending on investment performance.
Not all pension schemes offer this option, so you may need to transfer your pot to another provider and that could involve a transfer fee.
You don’t have to choose just one option
You don’t have to put all your eggs in one basket, taking instead a ‘blended’ approach to your retirement income. For example, you may choose to use just part of your pension savings to secure a guaranteed income with an annuity. The rest could be invested for flexibility and potential growth through drawdown.
That way, you might use an annuity to cover essential outgoings like housing, food and utility bills, and keep the rest in drawdown to fund lifestyle spending and unexpected costs.
Cutting through the complexity
Choosing what to do with your pension pot depends on your individual circumstances. Your health, expected retirement length, attitude to risk and income needs all play a part.
Before making any decisions, consider speaking to someone who can help you understand your options. That could be in the form of information and guidance from an annuity broker, advice from a financial adviser, or both. Whatever help you get, it’s all about navigating the options and choosing the best path for your retirement.