How does pension drawdown work?

When thinking about your retirement, one of the key decisions to make is in the type of pension you want to take out. 

You can usually take up to 25% of your pension savings as a tax-free lump sum when you hit retirement, while the remaining 75% can then be accessed in a few different ways: 

• An annuity gives you a guaranteed income for life or a fixed term.
• A drawdown fund is invested in the stock market to provide a regular, adjustable income.
• You can take some or all of it as cash.

How does a drawdown pension work, and what does it mean? This article will answer these questions and more. For further information about pensions, see our pension guide.

How does pension drawdown work?

Pension drawdown gives the holder the ability to take an income from their pension pot while leaving the rest invested in the stock market. 

Taxed as income, a drawdown fund can be accessed in the form of lump sums or as a steady, regular income (or both). As an investment, these funds tend to be looked after by wealth managers who act on behalf of the beneficiary. Any unused funds are passed on when you die tax-free.

What does pension drawdown mean?

Pension drawdown means that there are no restrictions on how much money you can withdraw from your pension savings each tax year. You could make regular monthly or annual withdrawals, or take a series of lumpsum payments when you need it. 

Since 6 April 2015, all new drawdown pension plans have the flexi-access drawdown option available. Under the current pension drawdown rules, drawdown generally becomes available at age 55 (57 from 2028). However, there are exceptions, such as terminal illness.

How pension or flexi-acess drawdown works is that you can take up to 25% of your pension as a tax-free lump sum while your remaining pension savings left invested in your pension. This pension drawdown rule means that 25% withdrawn from your pension is not subject to income tax. 

However, any withdrawal after taking your 25% tax-exempt lump sum is taxable as earnings in the withdrawal tax year. Also, further tax on pension drawdown may apply if the total value of your pension is above the pension lifetime allowance of £1,073,100 for the 2022/23 tax year. 

When is income drawdown a good option?

Income drawdown can be used as an alternative to taking money out of your pension when you’re not yet ready to retire but you’ve reached the retirement age. Income drawdown plans are beneficial to investors with pension funds invested in the stock market as it has an excellent chance to increase in value. 

However, this option means that income drawdown is a risky investment strategy because your investments may also lose value, and you might end up with less money than intended. If you’re going to use income drawdown, you’ll probably only be able to do so if you have a large pension fund.  

Apart from having a six-figure pension, you can also consider income drawdown if you have other incomes, such as a state pension, personal pensions and savings, so you don’t run out of money. 

If you want an income drawdown from a workplace pension scheme, you may require a pension transfer from a workplace pension to a private pension. Find out more about pension income drawdowns from a financial advisor before deciding whether this is a good option.

The benefits of pension drawdown

Arguably the most valuable feature of pension drawdown is its flexibility. Incomes from drawdown can be increased or decreased where necessary at any time, giving the beneficiary the control to plan their retirement income in the short and long term. 

Drawdown funds also allow for larger lump sums to be taken out in an emergency, while yearly contributions to the fund are tax-free, up to £4,000 a year. You can use your pension pot to buy an annuity if you want, and this option guarantees a regular income for the rest of your life or a specific period. But when comparing an annuity vs drawdown, a drawdown fund offers far more room for manoeuvre financially. 

Those with drawdown funds also have the flexibility to buy annuities later. A short-term annuity will provide regular payments for up to five years, which can be an ideal choice for those who expect their income needs to remain consistent over a shorter period of time. 

The drawdown also allows for any remaining funds to be inherited tax-free. Almost all annuities stop completely on your death, with some including the option to continue to have a small amount paid to your spouse. The ability to pass your investments on means drawdown is attractive for those who want to leave a larger inheritance. 

Things to consider about drawdown

There are a few things to consider before you opt for a drawdown fund. The first is risk; the pension pot being invested in the stock market means that it is subject to market movements. 

Investors can lessen their exposure to short-term fluctuations by taking a relatively conservative, long-term view. Fundamentally, the drawdown option is suitable for those who can accept a degree of risk – this risk can be factored in to retirement planning but not completely voided. 

Every decision around pensions should be taken well in advance of retirement, but none more so than the growth and management of a drawdown fund. So for instance, if you plan to retire at 55 and don’t plan to take out money till age 60, you should consider the estimated value of your investment upon retirement.

These things considered, a drawdown fund requires both active management and a degree of financial acumen to make it work. For many, this will mean having the scheme managed by a financial adviser with the expertise to keep a pot healthy. 

Why Moneyfarm?

Drawdown funds are, ultimately, a form of conservative investing. They need to be treated as such and handled by experienced wealth managers who offer the right blend of guidance and flexibility. 

At Moneyfarm, we put that balance at the heart of our business, and our pension drawdown service is no different. We help our investors make confident, informed decisions about their retirement incomes while removing the universal stresses that can come with it. 

Flexible withdrawals mean you can access your pension savings how and when you need to, with no additional fees. 

Diversification is a key feature of any robust drawdown fund, and our proven investment strategy makes full use of globally diversified assets. 

Human guidance helps our clients cut through the jargon associated with investing. We’ll also handle all the admin for ultimate comfort and freedom when you retire.

Low costs, when compared with traditional financial advisers, mean that you’ll keep more of your returns over the long term and, ultimately, take more into retirement. 

What are my drawdown options?

Our drawdown product is split into three options to give all of our investors what they want from their retirement fund. 

Each caters to different retirement plans and different ways of managing money, but the fundamentals are as follows: 

A Pension Commencement Lump Sum (PCLS) is a lump sum withdrawal that allows 25% of the pot to be taken at once or in instalments tax-free. So it won’t restrict how much you can save in your pension each year, and the remaining funds will be left invested to grow. 

A Flexi-Access Drawdown sees the fund taken as taxable income in monthly, quarterly or annual instalments, with the rest left invested to grow. You can adjust the frequency and the amount as required, and you can combine this option with the PCLS. 

An Uncrystallised Funds Pension Lump Sum (UFPLS) allows for ad-hoc lump sum withdrawals when the investor chooses. You can usually take 25% of each withdrawal tax-free, and the rest will be left invested to grow. 

Not sure which applies to you? Our investment advisory team is on hand to run you through your options and discuss your financial situation in more detail – get in touch for more information.

FAQ

What are the advantages of a drawdown pension?

With drawdown plans, you have control over your pension pots and can invest them in ways that best suit your needs. You can also access your pension pots in a way that suits you best – for example, lump-sum payments and flexible income streams.

What are the flexi-access pension drawdown tax rules?

You’re entitled to an initial lump sum of up to 25% from your pension pot each tax year, which is tax-free. After that, any subsequent withdrawals will be taxed based on your income tax rate. For the remaining 75% pension pot, you can withdraw all of your pension or take regular payments or a series of lump-sum payments (even before 55). 

Is pension drawdown right for me?

When choosing a pension drawdown, there are several factors to consider, such as if you want pension income flexibility, manage your annual tax liability, and keep your remaining pension pot investment. A pension drawdown might not be right for you if you have a yearly guaranteed income.