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How does pension drawdown work?


Michelle Monck

Michelle Monck

Consumer Finance Expert

At a glance

  • There are no limits on how much you can withdraw from a contributory pension
  • Once you use pension drawdown the amount you can save into your pension is reduced
  • 25% of your pension pot is available tax-free when using drawdown
More about pensions

What are the choices for your pension savings at retirement?

If your pension savings are in a defined contributions scheme you can choose to leave your retirement savings untouched and allow these to potentially grow further, buy a guaranteed income with an annuity or use pension or income drawdown. We explain more about pension or income drawdown in this guide.

What is pension drawdown and how does it work?

Pension drawdown rules mean that there are no limits on how much you can withdraw from your pension fund each year. You can take a tax-free lump-sum of 25% of your total pension pot up-front with your remaining pension savings left invested in your pension fund. Any income or withdrawals then made from your remaining funds would be taxed at your appropriate income tax rate. You can also choose to only make withdrawals from your pension as and when you want and not to receive the 25% lump-sum. In this case you would receive 25% of each withdrawal tax-free with the remainder taxed at your usual income tax rate.

Pension or income drawdown gives you the flexibility to access cash when you need it, with the chance that your remaining funds can continue to grow. You will need to carefully manage your withdrawals and monitor your pension fund growth to make sure you do not run out of money too soon.

The minimum age to access pension drawdown and not incur a tax penalty from HMRC is 55, however some pension funds may have a higher age so you will need to check with your provider. In 2028 the minimum age for drawdown set by the Government will increase to 57. However, once you use pension drawdown the amount you can save into your pension will reduce from £40,000 or 100% of earnings (whichever is lower) to £4,000 per year.

You may need to transfer your pension to a flexible pension in order to access income drawdown from your pension savings. You should take advice from a financial adviser when considering a pension transfer. When you choose a flexible pension with income drawdown you can usually review how your money is invested and adjust your investment choices to match the level of risk you are happy to take.


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Understanding the risks - traditional drawdown

This involves you designating all or part of your pension fund as drawdown funds, which will allow you to withdraw the money (or "draw down" the pot) as you see fit. You can still take up to 25% of the fund as a tax-free cash lump sum, with any additional withdrawals being used as taxable income. The rest of the fund will remain intact and will continue to be invested in your chosen pension funds. There are no limits on how much you can take as income.

Risk 1 – Running out of money

The average retirement is longer than most people think, so that need for income could be for over 30 years. If you don't manage your income you could very easily run out of money from your pension pot, so it's important to carefully plan your annual drawdowns to ensure you don't spend it too soon. Exhausting your pot may be fine if you have income from other pensions or a full State Pension to fall back on, but if your pension pot is the basis for your main income in retirement, think carefully about taking too much too soon. Unlike with an annuity, drawdown doesn't guarantee you an income for life.

Risk 2 – Tax-free cash

In a traditional drawdown arrangement, you have to say at the outset how much of the fund you want to designate as drawdown funds, and crucially, how much you want to take as tax-free cash. If you don't, you'll lose the ability to take any cash tax-free, so you'll end up paying more tax than you need for the rest of your retirement.

Risk 3 – Investment performance

The funds that you designate for drawdown are still invested in your chosen funds, so any downturn in investment markets can result in your fund value going down. This means you will need to carefully select where your funds will be invested. Most people in drawdown choose to move their funds into lower-risk areas to avoid large fluctuations in their value.

However, if you go too safe, and keep your drawdown funds in cash, you risk losing out on a significant amount of pension income due to the effects of inflation. According to the Financial Conduct Authority, customers who keep their funds in a mix of different types of investments can expect an increase in their annual income of 37% over a 20-year retirement. For this reason, they are looking to ensure customers make an active choice to keep funds in cash rather that this being the default choice at retirement.

Understanding the risks - taking regular payments

The Government calls these payments 'Uncrystallised Fund Pension Lump Sums' (UFPLS). Essentially, it means taking cash directly from your pension pot and using it like a bank account. The first 25% of each payment is tax-free, with the rest being taxable as income.

As well as the risks of running out of money and poor investment performance (as with drawdown), there are some other specific risks with this type of arrangement.

Risk 1 – Losing out on tax-free cash

As each payment includes a tax-free element, not all the available tax-free cash can be accessed up front. Most people like to access the full amount of tax-free cash at the outset, either to spend or to supplement their other income in a tax-efficient manner, something that this arrangement doesn't offer.

Risk 2 – Charges

However you choose to take your income, there will be some charges involved. Taking regular payments out of your fund is likely to be the costliest in terms of the fees and charges payable to the provider. These can eat into your retirement income and could mean you run out of money sooner.


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What are the fees and charges for pension drawdown?

There is no one approach to fees for pension drawdown with some providers charging set up, monthly and transactional fees, while some may not charge at all. Set up fees when charged are in the region of a few hundred pounds.

Pension drawdown and advice

You do not have to take financial advice when choosing pension drawdown. However, you may choose to do so to help ensure you make the best decisions possible. Taking advice will always be the best option, however for many reasons a significant proportion of people do not take, or cannot access advice. So, if you are not going to take advice, what do you need to consider to get the best outcome?

Risks and responsibility

Drawdown comes with a lot more risk than simple buying an annuity. The key risk is running out of money during your retirement. Therefore, both before and after you retire you need to build a plan and carefully monitor how much you wish to withdraw each and every year to stay on target. Checking regularly if your plan remains on track and is expected to give you the income you want over the remainder of your retirement is ideal.

How to build a plan?

If you seek advice in planning for retirement the adviser should build you this plan along with advising on a suitable provider and investments. If you do not, you will need to find planning tools and make decisions on a suitable provider and investments yourself. You can visit PensionWise to find out more information and use their simple calculator to see how far your pension pot will go. This is great start, however, it is likely that you will need something more sophisticated to fully answer the questions above and make the right choices to get the best outcome, if you are not taking advice.

Who offers pension drawdown?

42 Self Invested Personal Pensions pension providers are listed by Investment, Life and Pensions Moneyfacts offer pension drawdown but fees and charges can vary significantly.

Who are the best pension drawdown providers?

Every year Moneyfacts holds the Investment, Life and Pension awards, this recognises those providers delivering excellent products and great service to their customers. In 2020 the winner of the best drawdown provider was Royal London, with Prudential UK being highly commended and Standard Life receiving a commended award.

Pension drawdown FAQs

How is pension drawdown taxed?

When using pension drawdown 25% of your total pension pot is tax-free. For example, if you had a pension pot of £80,000 and decided to only take a regular monthly sum of £1,000 form your pension, then £250 would be tax-free each month. The remaining £750 would be subject to tax at your usual rate. If you decided to take an up-front lump sum of 25% of your pension pot then this would be tax-free, with any future income then taxable at your appropriate rate of income tax.

Is pension drawdown better than an annuity?

Our guide Annuities vs drawdown which is right for you explains more about the pros and cons of annuities and drawdown.

How safe is pension drawdown?

From the perspective of earning a regular guaranteed income, pension drawdown can present more risk than an annuity. This is because once you buy an annuity your income is guaranteed for life, whereas with pension drawdown, your remaining funds are invested in the stock market, which could go up or down in value. If there is a fall in the value of your funds you could receive a lower level of income in the future. A financial adviser can help to identify how relevant pension drawdown is for you.

Is pension drawdown classed as income?

Yes, income drawdown from your pension is classified as income and is subject to income tax after your 25% tax-free allowance has been used.

When was pension drawdown introduced?

The new pension drawdown rules came into force in 2015.

What happens to my flexible pension after I die?

If you die while you are receiving a regular income from pension drawdown your dependents can choose to inherit this. If you are below 75 then they can receive this tax-free, if you are older than 75, they will need to pay income tax on this at their regular rate. They could also choose to use the fund to buy a guaranteed income with an annuity, and this would incur income tax at their usual rate.

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