Pension freedom rules introduced in 2015 opened up a much wider range of options for those retiring, but it’s not always easy to work out which is right for you.

Current pension freedom rules will only apply to you if you have a defined contribution pension, sometimes known as a money purchase pension, where the amount you’ll receive at retirement depends on how much you (and your employer if it’s a company scheme) have paid in, and how well your investments have performed. These rules don’t apply to defined benefit or final salary pensions, which provide you with a guaranteed retirement income that is equivalent to a proportion of your final salary. You can find out more about the differences between defined contribution and defined benefit pensions in our guides What is a defined contribution pension? and What is a defined benefit pension?

Here we explain the various options for using your defined contribution pension pot, and look at some of the pros and cons of each.

If you’re thinking about getting professional financial advice, you can find a local financial adviser on VouchedFor or Unbiased.

Alternatively, if you’re looking for somewhere to start, we’ve partnered with independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.

Fidelius are rated 4.7 out of 5 from over 1,000 reviews on VouchedFor, the review site for financial advisors.

Buying an annuity

Before pension freedoms came into effect, most people used their pension savings to buy an annuity, or income for life, when they reached retirement. An annuity is essentially a contract with an insurance company. In return for handing over some, or all of your pension savings, you’ll be paid a guaranteed income with the amount of income you’ll receive dependent on factors such as your age and health.

If you decide to buy an annuity with your pension, many people choose to take 25% of their pension pot as tax-free cash and spend the other 75% on the annuity. Income you receive from your annuity is taxable.

Whilst still suitable for many, annuities are much less universally used than they used to be for a couple of reasons. Firstly, although annuities provide peace of mind that you’ll receive a guaranteed income while you’re alive, they usually die when you do, so any remaining pension savings stay with the insurer providing the annuity – as opposed to being passed to your family.

Secondly, annuity rates, which determine how much income you’ll receive from a given amount of pension savings, have been low in recent years, although they are currently much higher now following fourteen consecutive increases in the Bank of England base rate since December 2021.

Annuities are typically used by people who want peace of mind that they’ll have a guaranteed amount of income available to cover essential outgoings, and it is possible to buy an annuity that will continue to pay an income to a spouse or partner when you die.

Find out more about how annuities work and the different types you can choose from in our detailed guide Annuities explained.

Using drawdown

If you’re looking for flexibility, then drawdown – often known as flexible drawdown or flexi-access drawdown – is a way of taking an income from your pension as and when you need it.

The rest of your pension stays invested, either with your current pension provider or another provider. Over the long term, this will typically allow you to benefit from any growth in the value of your investments but it’s important to bear in mind that as your money remains invested, your pension savings could fall as well as rise in value, so you’ll need to be comfortable accepting this risk.

You’ll usually still be able to take out 25% of the funds as a tax-free lump sum at the outset.

There’s another kind of drawdown scheme available, called the Uncrystallised Fund Pension Lump Sum (UFPLS). Rather than taking a 25% lump sum payment at the start, each time you draw down money from your pension, 25% of it will be tax free, and the remaining 75% of the payment is taxable.

When you die, any money that’s left in your pension pot, can be passed on to your loved ones tax-free if you’re aged under 75 when you die. If you die aged over 75, your beneficiaries will simply have to pay income tax on any income taken from it. They won’t typically need to pay inheritance tax (IHT) on drawdown money, as it’s considered to be outside of your estate. Learn more in our guides What happens to my pension when I die? and Can my pension be used to reduce inheritance tax?

 

However, if you’re considering using drawdown to take a flexible income from your pension, always make sure you have sufficient cash or a guaranteed income – this could be your state pension, an annuity or defined benefit pot – to cover the essentials.

You can find out more about pension drawdown in our guide to How pension drawdown works.

Taking your whole pension as cash

Pension freedom rules also mean that you can take your whole pension pot as cash if you want to. Tempting as it might sound to have a big chunk of money sitting in your bank account, this option shouldn’t be taken lightly, and there are several significant drawbacks to consider.

For example, as only the first 25% of your pension is tax-free, you’re likely to end up with a hefty tax bill as the money you take out of your pension will be added to the rest of your income. With income tax rates charged at between 20% and 45% this could mean you end up giving away a significant chunk of your savings to the tax man.

Once you’ve taken your 25% tax-free lump sum, it is usually much more tax efficient to take a smaller amount from your pension pot each year, rather than taking the whole lot in one tax year, to make the most of your annual income tax allowances. Find out more in our guide How much tax will I pay when I withdraw my pension?

There’s also the risk that you’ll spend too much of your pension pot too soon, and you could end up running out of cash. You also need to bear in mind that if you put your retirement savings into a deposit account, the purchasing power of your cash may not keep up with inflation, or rising living costs.

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.

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Leaving your pension untouched

If you’re retiring but have other sources of income in addition to your pension, perhaps from a buy-to-let property, or from other savings, investments or the state pension, you might decide to leave your pension untouched until you need it.

The main benefit of accessing your pension later is that your savings will hopefully have more time to grow, providing you with a higher level of income when you eventually come to take money from it. Just be aware that as your money remains invested, your pension savings could fall as well as rise in value, so you may want to speak to a financial advisor to ensure that your investments are in the most suitable place for you.

You can find out more about why you might delay taking your pension in our guide Eight reasons you might decide to defer your pension.

Tax and your pension income

When you take money out of your pension, the first 25% is tax-free, whereas the rest counts as taxable income.

If you take a large amount out of your pension in one go, this could push you into a higher tax bracket. Many people opt instead to take their money out slowly over several tax years so they can keep income tax bills to a minimum.

Read more about taking a tax-free lump sum from your pension in our article Should I take my tax-free pension cash at 55? and about how pension withdrawals are taxed generally in our guide How much tax will I pay when I withdraw my pension?

When can I access my pension?

You can usually take some or all of your defined contribution pension out once you reach the age of 55.

There’s a 10-year gap between the pension freedom age and the State Pension age, so the age at which you can access your retirement savings is due to rise to 57 when the State Pension age reaches 67 in 2028. Not all pension schemes allow you to access your pension at this age though, so you’ll need to check with your provider to see when you can start taking your retirement benefits Find out more in our guide When can I retire?

Although taking money out of your pension as soon as you’re allowed to might be appealing, especially if you’re struggling to cover rising living costs, think carefully before doing this, as it will mean you have less to live on later and can affect your entitlement to certain government benefits. Find out more about the pros and cons of dipping into your pension to boost your income in our article Should I use my pension to boost my income?

If you’re thinking about getting professional financial advice, you can find a local financial adviser on VouchedFor or Unbiased.

Alternatively, if you’re looking for somewhere to start, we’ve partnered with independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.

Fidelius are rated 4.7 out of 5 from over 1,000 reviews on VouchedFor, the review site for financial advisors.

What if I have an older pension that doesn’t offer all these choices?

Not all pensions offer the same level of flexibility that newer pensions do, so if yours doesn’t, you may want to consider moving your retirement savings to one that does.

Zoe Bailey, chartered financial planner and director at wealth manager Evelyn Partners, said: “If you retain an older pension, when the time comes for you to want to access it, you may not be able to do so in the way your need or wish, and you may have to transfer it anyway to a more modern policy in order to receive the benefits you are looking for. Also, with a new flexible income drawdown option, once you have begun to receive the pension benefits in the way you want, you can also then reinvest the remaining funds with the aim of helping them grow to provide you with your desired ongoing retirement income.”

Ms Bailey also pointed out that in some cases there may be fees to transfer your pension, which may include exit fees, although there are providers who allow you to transfer free of charge. She said: “The cost of transferring will vary between providers, and you’ll need to work out if the exit cost is balanced out by the benefits of the more modern pension policy or a potentially cheaper ongoing charge for the new pension. You may be able to consolidate all your pensions into one policy and pay less charges overall.”

Transferring pensions shouldn’t be entered into lightly, as depending on the type of pension you have, you could lose valuable guarantees or benefits, so it’s important to seek professional advice first. You can find out more about the benefits and drawbacks of consolidating your pensions in our article Should I consolidate my pensions?

Where to go for more help

There’s no ‘one size fits all’ solution when it comes to deciding what to do with your pension pot when you retire. You’ll need to weigh up the various choices carefully and think about whether you’d prefer a regular guaranteed income, or prefer a more flexible approach where you take money out as and when you need it. You might like both these options, and choose to use a combination of both, so that you have some guaranteed income, whilst leaving the remainder of your pension invested. It’s worth seeking professional advice before making any decisions, so that you can be certain you’ve made the right choice.

If you’re 50 or over and have a defined contribution pension, you can get free guidance 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. 

If you’re thinking about getting professional financial advice, you can find a local financial adviser on VouchedFor or Unbiased.

Alternatively, if you’re looking for somewhere to start, we’ve partnered with independent advice firm Fidelius to offer Rest Less members a free initial consultation with a qualified financial advisor. There’s no obligation, however if the adviser feels you’d benefit from paid financial advice, they’ll talk you through how that works and the charges involved.

Fidelius are rated 4.7 out of 5 from over 1,000 reviews on VouchedFor, the review site for financial advisors.

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