Money Minder UK

What is Pension Drawdown & How Does it Work?

As you start to near retirement, you may be looking for additional income streams. Perhaps you’ve reduced your hours at work but want to enjoy the same standard of living, or are looking to maximise your earning potential with other types of investments. 

Although you might be able to cash in your pension when you reach 55, it can be risky as your investments will no longer deliver returns and you could run out of money in later life.

A pension drawdown can offer the best of both worlds – but what exactly is it and how could it benefit your finances?

What is a pension drawdown?

Under the pension drawdown rules, from the age of 55, you can draw a retirement income from the funds you’ve deposited, while leaving the bulk of the original investment in place.

This means you can withdraw unlimited funds directly from your pension either as a lump sum or as a regular cash income. 

Drawdown pensions enable a high degree of flexibility, particularly where a holder is drawing a regular income as opposed to taking a lump sum. Income payments from the fund can be set at varying intervals and amounts, which can be altered with relative ease if your circumstances change.

Those who choose the drawdown pension are free to use the income for a range of purposes, from making large one-off investments, either in assets or other financial products such as bonds, or for providing regular financial support for loved ones.

The pension drawdown differs from the more traditional annuity option, an insurance product that guarantees the holder an income for the remainder of their life at which point the policy ceases.

Whereas the annuity option entails purchasing an insurance policy on retirement with all the funds in a pension, the drawdown option keeps an amount of a fund in place. As such, the fund remains an investment capable of growing and delivering further future value.

A drawdown places the onus on the holder to take responsibility for their subsequent financial decisions and investments, which can go up or down in value, and to be prudent in how much they withdraw. 

What are the advantages of a pension drawdown?

A drawdown allows you to enjoy the benefits of the pension you’ve invested into for years, on your own terms. 

This might be in the form of a lump-sum for a major investment – say in a second home abroad – or regular, flexible income payments which can be used to invest in a range of options to generate further growth. 

The policy also enables a holder to continue paying into their pension, building on their original investment and potentially increasing the income stream from it. Funds can also be switched to a designated person in the event of the holder’s death.

Among the freedoms available under a drawdown pension is the ability to invest some of the income from the fund into various options including short-term annuities, shares and bonds.

If a pension-holder dies before the age of 75, their loved ones can receive the entire sum remaining in a drawdown tax free.

How does pension drawdown work?

The pension drawdown rules can seem complex, and there are important decisions to be made. 

The first of these is to decide whether or not a drawdown is the right option for you – there are other routes, which may be more suitable depending on your individual circumstances. 

pension drawdown calculator will tell you exactly how much income you can expect. This will produce a report unique to each person, based on various factors including the amount of money available in your pension fund and the income level you’re expecting. 

Since 2015, all former capped and flexible drawdown pensions have fallen within the definition of the Flexi-access drawdown (FAD).

Under the terms of a FAD, a person may choose to withdraw as much money from their pension pot as they like. 

The first 25% of any income withdrawn is tax-free, with the remaining 75% of the amount taken out being taxed as income.

Drawdowns are subject to HMRC regulations, and ongoing charges from providers managing your investments.

When is a pension drawdown a good option?

Pension drawdown isn’t for everyone. It is important to understand how your own circumstances might or might not be suited to it, or if you would be better off with other options, such as annuities.

Leaving funds within a pension usually means leaving them invested in the stock market. As trading conditions vary, these funds are subject to the same fluctuations as all shares, potentially diminishing the benefits of the drawdown option compared to the more secure annuity.

The larger the pension pot in the first place, the more benefit you get from the drawdown option. This follows the simple rule that money makes money – conversely the yield from a low initial investment can be minimal and a pot may be quickly drained.

One of the groups which benefit from the drawdown option are people who plan to continue working part-time into their retirement, using the income from their pensions to supplement their daily lives.

Other ways of taking your pension

As mentioned above, financial advisers have traditionally urged their clients to take annuities once they reach retirement. While the drawdown has become immensely popular, there are other potentially better options.

Annuities provide more stability than the drawdown pension option because they guarantee a fixed amount of income each month for the rest of your life. This is iron-clad and cannot be negatively impacted by dips in the stock markets. 

For a pensioner not interested in making investments, or averse to leaving their savings out in the markets, annuities can be a more cautious solution.

There are various options within this broad category of pension, including the lifetime, fixed-term, investment-linked and enhanced annuities – each with their pros and cons. 

Besides these two core types there might be many more options open to you. These vary according to the number of dependents you have, the expectations you have for your retirement, protections against future inflation and more. 

What’s the difference between drawdown and annuity?

This is explored in depth in a separate blog, but broadly speaking, annuities differ from drawdown pensions in two fundamental ways.

A drawdown option enables you to access some or all of the money in your pension as a source of income. This can provide for a steady, regular income in retirement, which if invested wisely, can be re-deposited in the same fund for a virtuous circle of growth.

The downside of this is that the pension can become more of a bank account, with funds depleted and returns reduced. Like any investment, it can also drop in value. 

Conversely, annuities guarantee a fixed income until death, and are not subject to the whims of a share index. However, they’re essentially an insurance policy. Payments are generally fixed and cannot be adjusted to compensate for changing circumstances.

Please be aware these articles are for general information purposes only and correct at time of printing. We will not accept responsibility for any errors made or actions taken by any readers that have acted on the information contained. Answers given are for guidance only and specific advice should be taken before acting on any of the suggestions made. All information is based on our understanding of current tax practices, which are subject to change. Always remember when investing, past performance is not necessarily a guide to future performance and the value of some investment units can fall as well as rise.