This page was last updated on 1 December 2020.
Pension Drawdown – A complete guide
What is a drawdown pension?
Your pension pot is invested in various types of assets to earn a return, and you draw an income from that pot.
Unlike with an annuity, this income is not guaranteed. But the upside is that your income may increase based on the performance of the assets it’s invested in. Another difference is that you can change how much you withdraw from a drawdown pension – you can choose to spend it faster or slower.
The level of income depends on how your investments are doing, as well as how quickly you want to spend your pension pot. You can choose from a number of drawdown options to find one which suits your situation. The effective rate of income also depends on how much tax you will have to pay.
Topics that you will find covered on this page
You can listen to an audio recording of this page below.
How much can I drawdown from my pension?
There isn’t much limit on how much of your retirement savings you can place in a drawdown fund. Your provider might refuse transactions under a certain low level, such as ten or fifteen thousand pounds. This is because, since you will have to pay certain fees, such a small amount of money is not worth putting in a drawdown pension.
In fact, it is worth bearing this in mind even if the pension provider offers drawdown options for small sums. Given the costs of transferring and the potential for flat fees that will really eat into the value of your pension, consider whether your savings are large enough for drawdown to be the right course.
There is usually no upper limit to the value of a drawdown pension.
Here is a short video explaining how a drawdown pension works.
What are some of the different types of pension drawdown?
There are a few types of plans through which you can draw down your pension savings: these are flexi-access and capped drawdown. (For clarification, you will hear the term ‘income drawdown’ a lot, and it does not distinguish some types of drawdown pension from others. It’s just another way of referring to pension drawdown generally.)
A flexi-access drawdown pension is the most common type of income drawdown, and if you put money in a drawdown fund today (or since April 2015) this is the type you are buying into.
Capped drawdown funds date from before the government changed how drawdown works. They are restrictive and no longer available to buy in to.
What is flexi-access drawdown?
All income drawdown pensions invested in after April 2015 are flexi-access, and they are characterised by their flexible withdrawal rates.
What are the rules for cashing in my flexi-access drawdown pension?
The level of pension withdrawal is largely under your control. Not only can you opt for a fund which matches your income preferences, but post-2015 drawdown rules allow you to increase your withdrawals and even take out a lump sum if you wish.
The first quarter you withdraw from your pension is tax-free, but subsequently all withdrawals are subject to tax regardless of their value.
What is a capped drawdown pension?
A capped drawdown pension was previously the only form of drawdown available. Capped drawdown schemes limited the withdrawals you were able to make.
For example, a capped drawdown fund might have stipulated that you may draw an income of no more than £1,000 per month. In this way, pension drawdown was much more similar to an annuity than it is today.
In April 2015, the system was changed, and now other income drawdown options are available. But since the change was relatively recent, there are still a lot of people out there with capped pension drawdown funds.
If you currently have one and you don’t mind its inflexible nature, there is no obligation to switch. But many will envy the flexibility and choice of newer income drawdown schemes. In these cases, it is often possible to switch to a flexi-access plan.
Can I leave my drawdown pension to my family when I pass away?
One of the biggest advantages of drawdown, as opposed to other pension options is the ability to easily pass money on to one’s beneficiaries. With an annuity for example, you can pay extra for a loved one to inherit an income stream when you pass away, but such options can be expensive.
You can usually only pass on an income rather than a lump sum, which makes it harder to help out your beneficiaries in getting on the property ladder.
But with pension drawdown, your beneficiaries receive the full value of your pension fund as a lump sum. If you pass away before you reach seventy-five, they could get the full amount as tax-free cash.
With the emotional strain of losing a loved one, avoiding a tax bill could make things easier for your family down the line. Even the limited beneficiary income options attached to some annuities are not tax-free.
If you live to see your seventy-fifth birthday, your beneficiaries will not receive the full value of your drawdown fund tax-free. How much tax your beneficiaries will pay depends upon the value of their earnings in that tax year.
What are the tax rules regarding pension drawdown?
You can withdraw a quarter of your pension as a lump sum without it being subject to tax. But all subsequent income will be taxed the same as earnings. So the tax rate you will pay on your drawdown income depends on your overall income in any given tax year.
As of the 19/20 tax year, you can earn £12,500 each year without paying tax at all. This is the same at any age, though older people previously had a higher personal allowance, this is no longer the case. You will probably earn more than that in taxable income, as the basic state pension alone is more than half this amount.
Your tax bills are likely to vary from year to year, especially if you opt for a flexi-access drawdown. But there’s no need to worry about calculating how much you’ll be liable to pay- your pension provider will do this for you. If you earned a salary during your career, you probably paid tax through Pay As You Earn, and it’s much the same with income drawdown.
Can I continue making contributions to my pension when I’ve started drawing down?
While there is nothing stopping you from making further pension contributions when you’ve started the drawdown process, you should be aware of the less favourable tax conditions.
Normally, and depending on your income, you can get tax relief on up to £40,000 a year of pension contributions. But under pension drawdown rules, you can only pay up to £4,000 per annum. This is known as the money purchase allowance.
Pension tax relief can, however, give you a bonus of twenty percent or more, depending on your income tax bracket.
How did the April 2015 reforms affect pension drawdown?
Far-reaching alterations to the UK’s pension freedoms were put in place on 6 April 2015. These made it easier to make one’s own decisions. One can now more easily take money invested in one scheme and place it in another, or vary contributions and withdrawals in accordance with your choice.
As mentioned already, these reforms made the now ubiquitous flexi-access drawdown available. But other changes were also brought into effect.
The reforms removed the strict obligation to purchase an annuity that was previously attached to many pension plans. Also, those who previously bought into a capped draw down pension fund now have greater autonomy.
The reforms also made transferring between pension plans easier, which may come in handy if your current scheme doesn’t offer drawdown. But to ensure safety for everyone, the reforms also created the obligation to seek financial advice for those transferring out of defined benefit pension schemes with £30,000 or more.
Can I choose pension drawdown if I am enrolled in a defined benefit plan?
Over ten million people in the UK are part of defined benefit pension schemes, in their final salary and career average variants. As a consequence, a lot of these people will find themselves wondering whether pension drawdown is possible in their case.
Unfortunately, pension drawdown is not an available option for those enrolled in DB plans. It might be possible for some pensioners to start drawdown indirectly by transferring to a defined contribution scheme first. It is a lot easier to begin drawdown from defined contribution schemes.
If you have a defined benefit pension and drawdown appeals to you, be aware that transferring a pension is something that should be done after a lot of consideration.
You can incur significant charges and risks. To minimise the disadvantages of the process, it is recommended that you seek independent financial advice. There is a statutory requirement to do so if your pension pot totals more than £30,000 anyway.
What if I am enrolled in a defined contribution pension plan?
A defined contribution (or ‘money purchase’) scheme is much more amenable to drawdown. This is because, unlike defined benefit schemes, these pensions can be thought of as a pot of money and investments in your name.
A defined benefit pension is more like a set of obligations that pension funds have towards retirees, such as the obligation to pay a certain proportion of your final salary, multiplied by the length of your career, etc. This means it is much easier to simply move money into a drawdown fund from a defined contribution scheme.
Discuss income drawdown with your employer or pension provider if it sounds like a suitable option for you. Most schemes offer income drawdown as an option, though it may depend on the value of your pension.
What is the difference between drawdown and an annuity, and which is right for me?
Since one of the main benefits of drawdown funds is the regular income they offer, it might be better to buy an annuity instead. Annuities differ from a drawdown pension in a few ways.
The main difference is flexibility. You can draw down pensions at whatever rate you like, so you can choose how much income you get. If you buy an annuity, withdrawals are fixed by the rules. So if you would prefer to vary your retirement income, drawdown products might suit your circumstances better.
But with a drawdown plan, your pension income has no guarantee. You will get back a different amount depending on the performance of the underlying investment. So a dip in the stock market could have an impact on your drawdown product. Retirees who don’t want to expose their pension pot to risk can purchase annuities.
Annuity payments are guaranteed. So if you prefer reliability to the potential for investment growth, using your pension savings to purchase an annuity could be a wise decision.
What are the benefits of drawdown?
- You can vary the amounts you withdraw over time, and even withdraw lump sums whenever you like. Greater control over one’s finances is a big upside for many.
- The ability to pass on your pension pot to beneficiaries as a lump sum – and potentially a tax-free one – is a huge advantage over annuities.
- As well as passing money on after you’ve gone, drawdown allows you to take out funds to give to loved ones in the here and now, though not tax-free. Normally, you can only give someone money from your pension if you divorce your spouse.
- An annuity rate will not increase if the shares and bonds in which the pension fund is invested perform well, whereas this is an option with drawdown.
What are the disadvantages of drawdown?
- The biggest downside is probably the lack of certainty. For many annuity holders, their guaranteed income provides invaluable peace of mind. Your drawdown income could fall if the underlying assets perform badly, as could the overall value of your pension pot. This is not the case with standard alternatives such as annuities and DB pensions.
- A draw down pension-in-payment severely restricts the tax relief you can claim on fresh pension contributions.
- Those enrolled in defined benefit schemes will have trouble moving to a drawdown fund, and may have to pay for a financial adviser. The cost of this service can range from hundreds to thousands, and you should question whether it’s worth your time and money.
Is pension drawdown a good idea?
On the whole, it depends on whether one values the advantages of drawdown more than the disadvantages. If you value flexibility over certainty, drawdown can be a great way to put your pension pot to use.
I am the primary writer and author for Help and Advice, having originally helped start the site because I recognised that there was a need for easy to read, free and comprehensive information on the web. I have been able to use my background in finance to produce a number of articles for the site, as well as develop the financial fitness score tool. This is a tool that provides you with practical advice on improving your personal financial health.
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