Ruth Jackson-Kirby
Tim Leonard
Pension drawdown, or pension income drawdown as it is also known, is a flexible way of accessing the money in your pension while it remains invested. This means you can draw a retirement income but your remaining pension fund retains the chance to benefit from investment growth over a longer period, an opportunity that is lost if you buy an annuity or take all of your pension savings as cash.
So how does pension drawdown work, what are the pension drawdown rules, and is pension income drawdown right for you? Read on to find out.
How does pension drawdown work?
Pension drawdown allows you to take – or ‘draw down’ – payments from your pension to provide a flexible retirement income. These payments can be set up to provide you with a regular income or can be taken on an ad hoc basis as and when you want.
Because of this, pension income drawdown is generally regarded as providing the most flexibility of all the options for accessing a pension at retirement. However, by remaining invested, there will always be the risk that your pension fund could fall in value or be depleted altogether. In turn, this means there is no guarantee that entering pension drawdown will provide you with an income for the rest of your life, unlike an annuity that will pay a regular income until you die.
» MORE: Your pension options at retirement
What are the pension drawdown rules?
Under the current rules, pension drawdown generally becomes an option from the age of 55. The only way you may be able to move into drawdown earlier is if you are in extremely ill health, have a terminal illness, or if your employment allows for a lower protected retirement age.
Income drawdown used to have stricter rules, with the government limiting how much income you could take unless you already received a certain retirement income level from other pensions.
Now, following the introduction of the pension freedom rules in April 2015, you can draw down as much or as little from your drawdown plan as you wish. However, making sure that you manage your withdrawals so that your pension fund lasts throughout your retirement should remain a priority. This is often referred to as having a sustainable income.
What pension do I need to go into income drawdown?
Pension drawdown can only be set up if your funds are held within a defined contribution scheme. This includes different types of personal pensions, such as self-invested personal pensions (SIPPs) and some workplace pensions.
However, not all providers of these pensions will offer pension income drawdown as an option, so it is worth checking with your pension provider. If you want to go into drawdown but your pension provider does not offer it, you can transfer your pension to one that does.
And if you have a defined benefit or final salary pension through your work, you could potentially transfer it to a defined contribution scheme if you wanted to make use of pension drawdown.
However, careful thought is needed before you transfer any pension – in particular from a defined benefit pension, which could mean you lose valuable benefits if you leave.
For this reason, seeking financial advice is always a good idea before proceeding with most pension transfers.
If you already have a personal pension or a workplace pension that offers drawdown, you will need to inform them of your intentions to get your move into drawdown underway.
But even if your current pension provider does offer drawdown, you should still compare its features and charges with other providers to make sure you get all the flexibility you need and don’t pay over the odds.
How to draw down a pension
When setting up a pension drawdown scheme, you can choose to take up to 25% of your pension fund as a tax-free lump sum.
The remainder is then invested but, going forward, you will have the option to:
- Withdraw all of your pension pot in one lump sum.
- Take regular monthly or annual payments as an income, while leaving the rest of your pot invested.
- Leave your pot invested and take lump sums out as and when you need to.
- Leave your fund invested and not make any withdrawals.
» MORE: Understand the pension withdrawal rules and limits
What is a pension drawdown fund?
You get to choose where the funds that you still retain after moving into pension drawdown are invested. As with any type of investment, when it comes to choosing between pension drawdown investment options, you will need to think about how much risk you want to take. Your plans for drawing down funds and making withdrawals should be considered too.
Because your funds remain invested, their value can fall as well as go up. So if the markets move the wrong way, or you make big withdrawals too quickly, there is a risk that your funds will run out, and your income comes to a halt.
Some pension providers offer ready-made ‘investment pathways’, which are designed to help you invest in a way that matches your plans for retirement. Alternatively, you could seek advice from a financial adviser for the best way to proceed.
» MORE: How to get pension advice
What are the pension drawdown tax rules?
Any payments you receive under pension drawdown once you have taken your 25% tax-free lump sum are subject to income tax for the tax year in which you take them.
Where you have other income, perhaps from the state pension, employment or investments, you may want to manage your withdrawals under pension drawdown to avoid stepping up into a higher income tax band.
Can you contribute to a pension after commencing pension drawdown?
If you want to continue contributing to your pension after entering pension drawdown, this is allowed.
However, once you have taken your 25% tax-free lump sum and started drawing an income, the most you can contribute to your pension and benefit from tax relief goes down from your usual annual allowance (which is the lower of 100% of your earnings or £60,000) to £10,000 a year. This is known as the Money Purchase Annual Allowance, or MPAA.
If you only take your 25% tax-free lump sum but no income, the MPAA doesn’t come into force, and you can continue contributing and receiving tax relief up to your annual allowance.
Other rules are also in place to stop people reinvesting – or recycling – their tax-free lump sum back into their pension, and therefore receiving tax relief on money that has received it previously.
» MORE: Learn more about pension tax relief and the MPAA
What drawdown pension charges could you face?
Drawdown pension charges can vary widely between drawdown providers and take many forms, including:
- set-up fees
- annual administration fees – either a flat fee or a percentage of your fund value
- platform fees
- dealing commission – payable when you trade funds and shares, which come with their own charges too.
The different structures providers adopt regarding pension drawdown charges can often make it difficult to compare drawdown costs, but it is essential that you do.
Is pension drawdown a good idea?
Pension income drawdown can be a suitable choice if you want flexibility over how you access your pension money and if you want your pension pot to remain invested so that it can continue to grow in retirement. However, it has its negatives and risks too, and certainly won’t be suitable for everyone.
Much will depend on your attitude towards risk and the level of financial security you want in retirement – a degree of uncertainty will always remain while your funds are invested. If the guarantee of a regular income for the rest of your life is important to you, a pension annuity is the only way this can be assured.
However, remember you don’t have to make a definitive choice between either drawdown, an annuity or withdrawing it all as cash – a combination of these options is an alternative as well and may be able to deliver the balance you are looking for.
Advantages of pension drawdown
- Your money remains invested so, depending on stock market performance, it could continue to grow in value.
- You can take money out of your pension whenever you want.
- You can vary the amount you take from your pension depending on your needs at the time.
- Drawdown can help with tax planning – you can structure your income withdrawals in the most tax-efficient way given your own personal tax situation.
Drawbacks of pension drawdown
- As your pension is still invested in the stock market, poor performance could erode the value of your pot.
- There is no guarantee your pension will last your entire lifetime.
- You are not guaranteed to receive a regular income.
- It can be difficult to compare pension drawdown charges across different providers.
What happens to my pension drawdown when I die?
If you are taking a pension through drawdown, your remaining pension can be inherited by your beneficiaries when you die. They will have the option of taking it as a lump sum or continuing to take an income from your drawdown plan.
How it is treated by the taxman will depend on your age when you die. If you are:
- Under 75 – Your pension can be inherited tax-free. Your beneficiaries have the option of taking a regular income from your drawdown plan or taking the whole pot as a lump sum.
- 75 or over – Your beneficiaries will pay tax on your pension at their personal rate of income tax.
» MORE: What happens to my pension when I pass away?
Beware pension income drawdown scams
If you are considering drawdown as an option, it is vital that you are aware of pension scams. If an individual or company contacts you unexpectedly with an offer to review your pension, explore transfer options, or provide access to your funds, you should treat them with caution.
You can check whether a person or company you are dealing with is bona fide by looking to see if they are on the Financial Services Register, or contacting the Financial Conduct Authority.
Where can I go for pension drawdown advice?
Moving into pension drawdown is a decision you need to get right. If you are in any way unsure of your options or not certain that what you’re doing is right, seek the help of a pension expert.
Everyone aged over 50 with a pension is entitled to a free pension consultation with the government’s Pension Wise service. What this offers, however, is only guidance.
For advice that is tailored to your individual circumstances, approaching an independent financial adviser could be a wise choice.
» MORE: How to get pension advice
WARNING: We cannot tell you if any form of investing is right for you. Depending on your choice of investment your capital can be at risk and you may get back less than originally paid in.
Image source: Getty Images
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