How pension drawdown works

Pension freedoms introduced back in 2015 have made it much easier to take an income from your retirement savings as and when you need it.

Drawdown – sometimes known as flexible drawdown or flexi-access drawdown – enables you to leave your pension savings invested once you retire, and draw an income from them when required. You’re also free to take a 25% tax-free lump sum out if you want to.

Drawdown rules only apply to defined contribution pensions, where the amount you receive at retirement is linked to how much you (and your employer if it’s a company scheme) have paid in, where your pension savings have been invested, and how these investments have performed.

If you have a final salary or defined benefit pension, the income you’ll receive is based on how many years you’ve belonged to the scheme and a proportion of your final year’s pay.

Advantages of pension drawdown

One of the main benefits of pension drawdown is the flexibility it provides. Retirees can decide how and when they take an income. This means, for example, that in years when you might have other sources of income, perhaps from part-time work, you may decide to draw down a limited amount, which you could then increase if your part-time work ends.

Another advantage of drawdown is that if you have any pension savings left when you die, these can be passed on to your beneficiaries tax-free, provided you’re aged 75 or less. If you’re older than 75 when you die, you can still leave your retirement savings to your beneficiaries, but they’ll usually have to pay income tax on the money they receive.

There are stories of some people with final salary schemes being tempted to transfer to a defined benefit pension to take advantage of this flexibility, but there are serious risks to consider and in most cases doing so is unlikely to be in your best long-term interests. Find out more in our article Should I transfer my final salary pension?

Risks of pension drawdown

The main risk of pension drawdown is that you might end up taking too much money out of your pension savings too soon. If you do this, or if your investments don’t perform as you’d hoped, you could run out of money, leaving you with only the State Pension to fall back on.

You also need to be careful how much you take out using drawdown. Only 25% of your pension can be taken as tax-free cash, so if you take out more than this, these withdrawals will be taxed at your marginal rate of income tax, which means the more you take out, the bigger your tax bill will be. It therefore makes sense to draw an income gradually to help reduce the amount of tax you have to pay.

It’s also worth remembering that taking a lump sum payment out of your pension via drawdown could affect your entitlement to means-tested benefits, such as Universal Credit, Housing Benefit or Pension Credit.  Once taken out of your pension they will be classed as capital in any calculations for means tested benefits. You can read more about how lump sum payments and savings can affect means-tested benefits here

How do I decide where my pension should be invested?

Where you decide to invest your pension savings while you draw an income from them will depend on your approach to risk, your investment time-frame and your financial objectives.

Unless you’re an experienced investor, it’s not always easy to work out which investments to choose, so it’s worth seeking professional financial advice about the best options for you (read on to find out where you can find an advisor).

If you choose not to seek advice, new rules were introduced this month (February 2021) to help drawdown customers decide where their pension savings should be invested. Essentially, these involve customers being presented with four different objectives by their pension provider, and asked to decide which one applies to them. This will then determine which ‘Investment Pathway’ they should follow.

You can find more about how these new rules work here.

Does it matter which drawdown provider I use?

Yes, it does, as charges can vary widely, and these can have a significant impact on your pension pot and future retirement income, so don’t just plump for your existing provider without first comparing what’s available elsewhere.

Recent analysis by Which? Money found that savers who switch drawdown providers when they retire could save as much as £12,300 over their retirement, assuming they have £250,000 in retirement savings invested over a 20-year period.

Which? found that charges can often be “opaque and unclear” and as a result three-fifths of drawdown customers stick with their existing provider when they start drawing money out of their pensions.

Jenny Ross, Which? Money editor, said: “The industry is still making it extremely difficult for savers to find and compare pension drawdown charges, which over time can make a startling difference to the size of your retirement pot.

“Some of the charges cannot be avoided, but other providers may offer the same investments at a lower cost, and savers are free to switch providers at any time.”

Alternatives to drawdown

Drawdown isn’t the only way your pension can provide you with an income, so make sure you consider all the available options before deciding whether it’s right for you.

For example, if you want a guaranteed income in retirement, you may decide to use some or all of your pension savings to buy an annuity. This is essentially a contract with an insurance company and in return for your savings you’ll be paid a set income for life, or a fixed term. The amount of income you’ll get will depend on a range of factors including how much of your pension you’re using to buy an annuity, how old you are, whether you want the income you get to increase each year, your health, and whether you want the annuity to pay out to your spouse, partner, or someone else after you die.

Not all providers will offer you the same monthly income for your money, so it’s essential to shop around and get the best deal for your circumstances. You can find out more about how annuities work in our article Annuities explained.

Bear in mind that choosing drawdown or an annuity doesn’t have to be an either/ or decision, and it’s possible to go for a combination of both. For example, some people choose to use some of their pension to buy an annuity so they have peace of mind their essential outgoings will be covered, and then use drawdown to take a further income from the rest of their pension savings as and when they need to.

You also have the option of cashing in your whole pension if you want to, and if your pension scheme allows it. However, in doing so, you run the risk of landing yourself with a potentially hefty tax bill, as only the first 25% will be tax-free and you’ll have to pay income tax on the rest. You’ll also have the added difficulty of working out where to keep your pension savings after you have taken them out. If you want to keep your money in a cash account, for example, rock-bottom interest rates mean your savings will soon start to be eroded by inflation, or rising living costs. According to financial website Moneyfacts.co.uk, the average easy access account in January 2021 paid just 0.18% annual interest – that’s equivalent to just £180 a year in interest on a balance of £100,000.

Cashing in your pension could also affect your entitlement to means-tested benefits too, so you must make sure you’ve fully considered all the financial implications involved before doing this. Find out more about how pension lump sums can affect means tested benefits here

Remember your pension allowances if you want to carry on paying into your pension

Prior to accessing your pension, you can pay up to £40,000 into your defined contribution pension every year, known as your Annual Allowance.

However, once you’ve started taking money out of your defined contribution pension, your Annual Allowance falls from £40,000 to £4,000 and becomes known as the Money Purchase Annual Allowance (MPAA). If any contributions you make into your pension exceed this amount, then you’ll have to pay a tax charge. This can make it really difficult to build your pension savings back up if you find you’ve withdrawn too much too soon. Find out more about the implications of using your pension to boost your income here.

The good news however, is that if you are able to keep investing into your pension after you have started to access it, you will still receive tax relief on any new top up savings up to the MPAA of £4,000 per year.

Finally, it’s helpful to remember that if you only take a 25% tax-free lump sum out of your pension but not any income, you can still keep your full £40,000 Annual Allowance.

How much income can I take from my pension before I run out of money?

It can be really difficult to know how much you can take from your pension every year via flexible drawdown – and let’s face it, no-one wants to take out too much so they end up running out of money during retirement.

Consumer association Which? has a really useful Drawdown Calculator which can help you see how long your money might last based on the amount of income you require, how much tax-free cash you want to take out, and where you want your pension savings to be invested.

Here are some examples, but remember that these are based on assumptions, and the value of your investments can fall as well as rise.

Example 1

You have £100,000 in your pension pot.

You choose to take 25% of this as a tax-free lump sum (£25,000) leaving you with £75,000 to invest.

You have a low appetite for risk, so choose a cautious portfolio, mainly invested in cash and fixed interest investments.

Assuming you’d like to draw down an income of £5,000 a year from this to supplement your State Pension, and you’d like to increase this by 2% each year to ensure it keeps up with inflation, you can expect to run out of money after 17 years.

Example 2

You have £150,000 in your pension pot.

You choose to take 25% of this as a tax-free lump sum (£37,500) leaving you with £112,500 to invest.

You have a moderate appetite for risk, so choose a portfolio which is mainly invested in fixed interest investments and stocks and shares.

Assuming you’d like to draw down an income of £8,000 a year from this to supplement your State Pension, and you’d like to increase this by 2% each year to ensure it keeps up with inflation, you can expect to run out of money after 19 years.

Example 3

You have £200,000 in your pension pot.

You choose to take 25% of this as a tax-free lump sum (£50,000) leaving you with £150,000 to invest.

You have a strong appetite for risk, so choose a portfolio which is mainly invested in stocks and shares, partly in fixed interest investment and has a small cash reserve.

Assuming you’d like to draw down an income of £12,000 a year from this to supplement your State Pension, and you’d like to increase this by 2% each year to ensure it keeps up with inflation, you can expect to run out of money after 17 years.

All these examples assume that once you retire, cash investments grow at an average of 0.50% a year, fixed interest at 4.75% a year and stocks and shares at 7.25% a year, and that there are ongoing annual charges of 0.3%. Outcomes could be very different based on alternative growth assumptions and charges.

Bear in mind too that you don’t have to take 25% of your pension as a tax-free lump sum. If you can afford to leave it invested, this could significantly boost your future retirement income. You can find out more about the pros and cons of taking tax-free cash in our article Should I take my tax-free pension cash at 55?

Where to go for advice on your pension

If you’re 50 or over and have a defined contribution pension, you can get free guidance available on the options available to you from the Government’s Pension Wise service.

However, if you want personal recommendations or advice about your specific circumstances, you’ll need to seek professional financial advice. You can find a local financial advisor on VouchedFor or Unbiased, or for more information, check out our guides on How to find the right financial advisor for you or How to get advice on your pension.

If you think you might be interested in speaking with a financial advisor, VouchedFor is currently offering Rest Less members a free pension check with a local well-rated financial advisor. There’s no obligation, but once you’ve had your check, the advisor will discuss the potential for an ongoing paid relationship if you think it might be useful to you.

Are you considering flexible drawdown, or are you already taking an income from your pension? We’d be interested to hear your views. You can join the money conversation on the Rest Less community or leave a comment below.

Links with an * by them are affiliate links which help Rest Less stay free to use as they can result in a payment or benefit to us. You can read more on how we make money here.

If you’re considering getting professional financial advice, VouchedFor is offering Rest Less members a free pension check with a local advisor. There’s no obligation but once you’ve had your review, the advisor will discuss the potential for an ongoing relationship if you think it might be useful to you.

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