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.
This has both advantages and disadvantages, as although dipping into your retirement savings could help you make ends meet during tough times, taking out too much too soon might leave you struggling financially later down the line.
In this article, we explain how to use pension drawdown, and some of the pros and cons you’ll need to consider.
- What is pension drawdown?
- Advantages of pension drawdown
- Risks of pension drawdown
- How do I decide where my pension should be invested?
- Does it matter which pension drawdown provider I use?
- Pension drawdown options
- Remember your pension allowances if you want to carry on paying into your pension
- How much income can I take from my pension before I run out of money?
- Where to go for advice on my pension
What is pension drawdown?
Pension 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.
Pension 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. You can find out more about defined contribution pensions in our guide What is a defined contribution pension?
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. Learn more about defined benefit pensions in our article What is a defined benefit pension?
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 pension 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. Learn more in our guide What happens to my pension when I die?
There are stories of some people with final salary schemes being tempted to transfer to a defined contribution 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.
According to latest HMRC data on flexible payments a total of £12.9 billion was withdrawn from pensions flexibly in 2022/23, compared to £11.2 billion in 2021-2022 and £9.3 billion in 2020-2021.
In the first three months of 2023 alone, £3.4 billion of taxable payments was withdrawn from pensions flexibly by 519,000 individuals, an 18% increase compared to the same quarter in 2022, with the average taxable withdrawal at £6,600 per person.
Tom Selby, head of retirement policy at AJ Bell said: “Anyone considering accessing their pension for the first time or hiking withdrawals to cope with rising living costs should stop and think before making a rash decision. Taking money out of your retirement pot early or withdrawing too much, too soon could have disastrous consequences over the long-term.
“What’s more, pensions benefit from generous tax treatment on death, meaning it often makes sense for your retirement to be the last asset you touch.”
Bear in mind too that 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 can therefore make sense to draw an income gradually to help reduce the amount of tax you have to pay. You can find out more about pension withdrawals and tax in our guide How much tax will I pay when I withdraw my pension?
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 use the Rest Less pension calculator to see a forecast of the pension income you’re likely to get when you retire, based on the current value of your retirement savings. This can include your State Pension entitlement if you want it to, and you can also see the impact of taking 25% of your pension as tax-free cash. You can amend your retirement age and the level of income you want, to see how these factors affect the length of time your pension will last.
Find out how to use the calculator and what it will show you in our article How to use the Rest Less pension calculator.
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 earlier this year 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.
Does it matter which pension 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.
According to analysis by Which? Money found that savers who switch pension 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 pension 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.”
Learn more about selecting the right drawdown provider for you in our guide How to choose the best pension drawdown provider.
Pension drawdown options
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 pension 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, the good news is that returns have increased in recent months following a series of interest rate hikes, although there are still no savings accounts offering returns which keep pace with inflation, or rising living costs.
According to financial website Moneyfactscompare.co.uk, the average easy access account in February 2023 pays 1.73% – that’s equivalent to £173 a year in interest on a balance of £10,000.
Cashing in your pension could also affect your entitlement to means-tested benefits, 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 How lump sum payments and savings can affect your benefits.
Remember your pension allowances if you want to carry on paying into your pension
Prior to accessing your pension, you can pay up to £60,000 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 £60,000 to £10,000 and becomes known as the Money Purchase Annual Allowance (MPAA). You can learn more about this in our article What is the Money Purchase Annual Allowance? If any contributions you make into your pension exceed the MPAA, 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 supplementing your income with your pension in our article Should I use my pension to boost my income?
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 £10,000 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 £60,000 Annual Allowance. You may be able to keep your full Annual Allowance if you’re cashing in a small pension. Find out more in our guide Cashing in small pensions: what you need to know.
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 a range of assumptions (see below), and the value of your investments can fall as well as rise.
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, you can expect to run out of money after 17 years.
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, you can expect to run out of money after 19 years.
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, 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 on the options available to you from the Government’s Pension Wise service.
If you’re considering getting professional financial advice, Aviva is offering Rest Less members a free initial consultation with an expert to chat about your financial situation and goals. There’s no obligation, but if they feel you’d benefit from paid financial advice, they’ll go over how that works and the charges involved.