How Does Pension Drawdown Work?
What is a drawdown pension? What are the pension drawdown rules? In this guide, we explain everything you need to know about pension drawdown and whether it’s right for you.
What is a drawdown pension?
Pension drawdown is something most pension companies offer. Also known as income drawdown, pension drawdown is a way of turning your pension fund into regular income when you retire.
Your pension savings remain invested even once you reach retirement age (minimum 55 years old). You can use your pension as income when you ‘drawdown’ from your pension fund.
This is why pension drawdown can sometimes be risky as your income will be affected by how the investments perform. Your pension fund could either rise in value or decrease which is why drawdown pensions aren’t for everyone.
How does pension drawdown work?
When you get access to your pension, which is usually from 55, you can transfer it to a drawdown pot. This means that your pension stays invested and you can draw money from it whenever you want.
By using pension drawdown, you have the opportunity for your pension to continue to grow, even when you retire and are no longer contributing to it. However, this also means that your pension fund could fall in value if the investments fall.
You can choose what income you want to take from your pension but it’s important to remember that the more you take, the less money you might have later in life.
What are pension drawdown tax rates?
The first 25% of your pension is tax-free. Any withdrawals you make past 25% are subject to standard income tax:
- £12,570 is tax-free each year. Unless you have any other income.
- 20% tax on the next £37,500 after that.
- 40% tax on anything above £50,000.
- 45% tax on anything above £150,000.
If you’re unsure, you can use a pension drawdown calculator to figure out how much tax you’ll be paying on your pension withdrawals each year.
What types of drawdown pension are there?
There are two main types of drawdown pension to choose from:
- Pension drawdown - released in 2015 when pension drawdown rules changed. There’s no limit on the amount of drawdown you can take from your pension. Pension drawdown arrangements made after the 6th April 2015 are called flexi access drawdown.
- Capped drawdown - was available until April 2015. There are limits on how much you can drawdown from your pension fund. The pension drawdown rules are also more restrictive. If you’ve got a capped drawdown arrangement, you should be able to switch to a flexi access drawdown.
What are the fees for pension drawdown?
There are no set fees and charges to set up a pension drawdown as it depends on the provider. Some pension providers might charge you to set up a pension drawdown whilst others might charge monthly or transaction fees. This is a good thing to compare when looking at different pension drawdown options.
Pension drawdown risks
With pension drawdown, you can withdraw your 25% tax-free lump sum. The rest of your pension will be invested into different funds, with the chance of your income increasing or decreasing in retirement. So, understandably, pension drawdown does come with its own set of risks:
Risk #1: You could run out of money
People can underestimate the length of their retirement which can be over 30 years long. So, if you don’t manage your pension drawdowns well, you could run out of money in your pension fund very quickly. Drawdown doesn’t guarantee you an income from your pension for life as you manage how much income you take each month.
So, make sure you plan for the next 30 years and work out how much you can afford to drawdown each month.
Risk #2: Losing out on tax-free pension
At the beginning of a pension drawdown arrangement, you have to agree how much of your pension you want to designate to drawdown funds and how much you want as tax-free cash.
This is really important to remember that you can withdraw up to 25% of your pension tax-free. So, make sure that you dedicate 25% as the tax-free cash or you’ll end up paying more in tax throughout your retirement.
Risk #3: Unpredictable investment performance
The rest of the funds you dedicate to drawdown are invested in your chosen funds. This means that any drop in the market could impact the overall value of your pension. So, you need to think carefully about what you invest your pension in.
Going too safe with your investments won’t grow your income. However, choose a sensible mix of investments and you can expect an increase in annual income of 37% over a 20-year retirement, according to the Financial Conduct Authority.
If you’re unsure, it’s best to discuss your drawdown pension choices with an expert.
What are the pros and cons of drawdown pensions?
If you’re unsure about a drawdown pension, take a look at the pros and cons to help you decide:
Drawdown pension pros:
- You can invest your money throughout your retirement. So, there’s a chance to boost the value of your pension.
- Your pension can increase in value during retirement, even once you’ve stopped working thanks to the investments.
- You can withdraw money from your pension when and how you please.
- You can manage your tax as you decide how much pension you withdraw.
- Pass savings onto your family tax-free (if you die before 75).
Drawdown pension cons:
- You haven’t got a guaranteed annual income as the value of your pension can fluctuate.
- If you worry about running out of money, drawdown pensions can cause anxiety.
- Some providers charge high drawdown pension fees.
- Investing is never risk-free and it might not be something you want to worry about in retirement.
Is pension drawdown right for me?
Knowing whether a drawdown pension is right for you can be a difficult decision to make. The risk of fluctuating investments can be overwhelming for many people.
Pension drawdown could be right for you if…
- You want to continually invest your pension money.
- You want the freedom to withdraw how much you want, whenever you want from your pension.
- You want to frequently change your pension withdrawal amounts.
- You want to manage your tax liability.
Pension drawdown might not be right for you if…
- You want guaranteed income every year.
- You worry about money.
- You aren’t interested in investments and the risks.
- You don’t want to pay any charges.
How to open a pension drawdown plan
Not all workplace pensions have a drawdown option. This means that if you want to drawdown from your workplace pension, you might need to transfer it to a different provider that offers drawdown.
If you already have a SIPP (Self Invested Personal Pension) then your provider will be able to switch it into a drawdown plan. Or, you can transfer your workplace pension into a SIPP and switch to the drawdown option.
Don’t rush into opening a drawdown pension, consider the risks first. For more information on SIPPs, read our guide.