Retirement planning has become more flexible, but increasingly complicated in recent years. A fixed retirement date and a guaranteed pension are no longer typical. People are living longer, healthier lives and retirement is full of opportunities. The option to tailor your income to your life stage can be very appealing.
Drawdown has been an option for many years, but has really taken off in popularity since 2015, when the new Pension Freedoms arrived.
So how does it work, and could it be for you?
What is Pension Drawdown?
Put simply, drawdown allows you to treat your pension like any other investment. It operates as follows:
- Your pension remains invested in your chosen funds after you retire.
- You can draw a tax-free lump sum of 25% from your pension fund. This can be taken when you retire or earlier, or even phased over a number of years.
- You select the level of income you require. This is taxable at your marginal rate.
- You can opt to take your income monthly, quarterly, annually, or ad hoc. You can vary it as required.
- In theory, you could withdraw your entire pension pot as a single lump sum. However, this is usually only advisable for smaller pots as otherwise, the tax bill will be significant.
- On death, your pension pot can be passed on to your loved ones whether you have taken benefits or not. If you are under 75, this can be paid out free of tax. If you are over 75, your beneficiaries can withdraw a flexible income, taxed at their marginal rate.
If you took benefits from your pension before 2015, your fund may still be in Capped Drawdown. The pre-2015 rules meant that there were certain limits on the amount you could withdraw.
If you do have a Capped Drawdown plan, it is usually simple enough to transfer this into a Flexible Drawdown contract to remove the restrictions. However, this will trigger the Money Purchase Annual Allowance, which limits future pension contributions to £4,000 per year. The best option for you will depend on your circumstances.
Many investors value flexibility over guarantees and find that the variable nature of a drawdown contract suits their retirement plans perfectly. Drawdown has the following advantages:
- You can still benefit from investment growth after you retire.
- Retirement income can be varied. For example:
- You may wish to take a small amount of income in the earlier years as you transition into full retirement.
- This can be increased when you stop work, or adjusted when other income sources (such as the State Pension) come into payment.
- You might find that you spend less as you get older.
- Care costs could apply later in life, requiring your income to increase again.
- As drawdown pensions can be passed on when you die, they can be a useful estate planning tool.
Of course, there are some risks and possible disadvantages:
- As the fund remains invested, it can fluctuate and even lose money.
- Taking an income from a reduced fund value can limit the potential for it to recover.
- It is possible to run out of money if your withdrawals exceed the investment growth.
- Taking income from a drawdown plan triggers the Money Purchase Annual Allowance, and limits your future pension contributions.
- If you take your income on an ad hoc basis, emergency tax may be applied rather than your standard rate. This can be reclaimed, but it takes time.
- A drawdown plan can be complex to administer and needs regular reviews.
- There are costs involved to manage and maintain the drawdown plan.
- Your fund will be tested against the Lifetime Allowance, not only when you first take benefits, but again at age 75. This places heavy taxation on fund values over £1,073,100 (as of 2020/2021).
- Not all contracts offer drawdown and you may need to transfer your pension to a new plan.
Drawdown should be considered as part of a comprehensive retirement plan, and financial advice is recommended.
Drawdown is not your only option when you retire. Assuming you have a standard money purchase pension, with no guarantees or scheme pension available, any of the following would be available:
You can use your pension fund (after you have taken your tax-free lump sum) to buy an annuity, which will pay you a guaranteed income for life. Your annuity rate will depend on your age, health, and lifestyle, as well as any options selected, for example:
- Index linking
- Spouse’s pension
- A guarantee to return some of your capital if you die in the early years
Annuities provide certainty, but any options must be chosen at outset. There is no scope to change your mind or add additional features as your requirements change, for example removing a spouse’s pension if your partner pre-deceases you.
Uncrystallised Pension Fund Lump Sum
Most people are aware that they can withdraw their full pension fund as a lump sum. But it’s also possible to withdraw it in phases. For example, if you have a £100,000 pension pot, you could take a lump sum of £10,000 per year for ten years. 25% of this would be tax free, with the remainder taxed at your marginal rate.
Many pension providers who do not offer drawdown will still allow you to take partial lump sum withdrawals.
Guaranteed drawdown or hybrid plans were another option. But between the expense involved and the aftermath of the financial crisis, they have fallen out of favour in recent years.
Drawdown might be for you if:
- You can cope with some investment fluctuation into your retirement
- You don’t want to make an immediate decision about whether to buy an annuity
- You would like to be able vary your retirement income
- You want to pass on some of your pension fund to your loved ones
- You have cash, other investments or other income, so that you are not fully dependent on the fund.
- You are prepared to set aside some cash within your pension to meet your short-term withdrawal requirements.
Drawdown is highly flexible and useful for many retirees. However, it is not for everyone and it is always worth seeking advice around your retirement options.