Pension Drawdown vs Annuity: Sequencing Income to Reduce IHT Risk

When unused pension funds count for IHT from 2027, the old rule of thumb—spend ISAs and taxable portfolios first, preserve the pension—stops being universally optimal. The new question is: how should retirement income be sequenced so that life is funded, income taxes are sensible, and the pension doesn’t remain unduly large at death?

How measured drawdown supports the plan

Flexi-access drawdown keeps capital invested and adaptable. It works best when withdrawals match real spending and are mapped across tax bands year-by-year. The aim is to draw what is needed, when it’s needed—without pushing into punitive marginal rates or forcing asset sales at poor market levels. Done well, drawdown gradually reduces the pension value that might otherwise be caught by IHT, while retaining investment potential for the long run.

What to weigh up with drawdown

• Market path risk: Withdrawals during down markets can compound losses; a reserve/cash bucket helps.
• Tax band drift: Annual allowances, personal allowances, and taper thresholds matter over time, not just this tax year.
• Survivorship: Income must remain resilient if one partner dies or if health needs change.

Where partial annuitisation fits

Annuities convert a portion of capital into a guaranteed income stream, often used to cover essential, non-discretionary spending. In IHT terms, exchanging part of a large pot for income can reduce the amount of unused pension left at death. Options such as joint-life, escalation, and guarantee periods shape both income certainty and potential benefits for a surviving partner.

Trade-offs to understand

• Flexibility vs. certainty: An annuity is stable but less flexible than invested capital.
• Rates and timing: Annuity rates fluctuate with yields and life expectancy; timing can be staged.
• Integration: The goal is complementarity—drawdown for flexibility and growth; annuity for essential spend and behavioural comfort.

Pulling income tax and IHT together

Sequencing works when income tax and IHT are viewed as a combined problem. For example, a household may accept slightly higher income tax over several years to avoid a much larger IHT exposure on an untouched pension. Conversely, over-withdrawing to shrink the pot can be counter-productive if it triggers needless higher-rate tax and undermines investment compounding. The balance is personal; the principle is universal.

Beneficiaries and documentation still matter

Even the best income plan falters without clean beneficiary nominations, coherent wills, and an agreed approach to who pays any pension-linked IHT. That administrative clarity protects families from forced sales and delays.

A practical framing

Think in layers: fund essential spending with a mix of secure income (annuity, state pension, guaranteed sources); use drawdown for discretionary or inflation-sensitive needs; manage the overall pension size so it isn’t unnecessarily large at death. Model multiple sequences, and test different market paths, tax bands, and longevity assumptions. The result is a plan that feels calm in life and coherent for heirs.