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Pension drawdown works by allowing retirees to take an income from their pension pot while still keeping the money invested. It is usually only available if you have a defined contribution pension, rather than a final salary or defined benefit pension. With a defined contribution pension, your pension pot is made up of contributions from yourself and your employer (if you have one). The value of your pension will depend on how the investment performs and the level of charges applied.
A defined benefit pension is arranged by your employer and are also sometimes called ‘final salary’ or ’career average’ pension schemes. How much you get depends on your pension scheme’s rules, not on investments or how much you’ve paid in. Workplace schemes are usually based on a number of things, for example your salary and how long you’ve worked for your employer. The pension provider will promise to give you a certain amount each year when you retire. You can usually choose to get 25% tax-free, and then you’ll get the rest as regular payments.
When you retire, you can use pension drawdown to receive pension income whilst allowing your pension fund to keep growing. Instead of using all the money invested in your pension fund to buy an annuity (see below), you can leave your money invested and make withdrawals as and when you need them. Not every pension policy will offer the same options, and this will depend entirely on your personal circumstances, tax position and what goals you want to achieve in retirement.
What is an annuity?
Annuities enable you to exchange your pension pot for a guaranteed income for life. They were once the most common pension option to fund retirement. But changes to the pension freedom rules have given savers increased flexibility.
With this option, the provider agrees to pay you an agreed regular sum until you die, however there are some products which may allow the income to continue even after your death. With an annuity, you may receive more or less money than you put in depending on how long you live after your annuity has started.
What is flexi-access drawdown?
When it comes to assessing your pension options, flexibility is the one of the main attractions offered by flexi-access drawdown, which enables you to access some of your money while leaving the rest invested, meaning your funds have the opportunity to grow.
When you reach the age of 55 (age 57 from 2028) you are permitted to access all or some of your pension pot. Although 25% of the amount you take is tax-free, you will pay income tax on the rest, and if you plan to withdraw a significant amount from your pension savings, you need to be sure you have considered all the implications and risks very carefully to avoid of running out of money during your retirement years. It’s worth remembering that the value of the remainder of your invested pot can go down as well as up depending on the level of income you take and any investment growth.
It’s important to note that money you receive from your pension is included when working out your entitlement to any state benefits. Taking a large lump sum in one go could affect the benefits you can receive; alternatively, taking a large sum could push you into a higher-rate tax band depending on your personal circumstances.
You should also be aware that if you are considering a phased retirement and wish to continue making pension contributions, your annual allowance will be reduced from £60,000 to £10,000, depending on how you access your pension. This is known as the Money Purchase Allowance (MPAA).
There are a number of key factors to think about when considering accessing your pension as to how long your pension pot will last; this means the income isn’t guaranteed or finite and if you don’t plan you could end up running out of money.
Can I take a combination and mix and match proceeds from my pension pot?
It may suit you better to use a combination of the options outlined above. You might want to use some of your savings to purchase an annuity to cover the essentials, for example, rent, mortgage, or household bills, with the rest placed in flexi-access drawdown that allows you to decide how much you wish, and can afford, to withdraw and when.
Alternatively, you might want more flexibility in the early years of retirement, and more security in the later years. If that is the case, this may be a good reason to delay purchasing an annuity until later.
Do I have the option to leave all my pension pot for now and defer my pension?
You could decide not to take your pension at your selected retirement date and leave it invested until you are ready to take your benefits. This means your pension pot has the potential to grow, although this is not guaranteed. It's a good idea to check whether your policy has any special features that mean restrictions apply. You should also check if you might lose any income guarantees or investment bonuses if you take it later.
Pension drawdown provides flexibility and the opportunity to access tax-free cash immediately and to vary your income according to your specific requirements. You can also potentially have more control the level of income tax you pay, and you have control of your investments depending how you chose to access your pension pot.
The funds benefit from investment growth in a tax-efficient environment and you have the choice of death benefits for your dependents. Utilising pension drawdown means you have the choice not to purchase an annuity and you can take unlimited amounts.
But you need to be aware that future investment returns are not guaranteed, and high withdrawals of income may not be sustainable. Your level of income could also change due to investment performance. The higher the level of income withdrawal you choose the less that may be available to provide for your dependents or for your later retirement years. And greater flexibility sometimes brings increased administration costs.
Please note: This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
The content was accurate at the time of writing. Whilst information is considered to be true and correct at the date of publication, changes in circumstances, regulation and legislation after the time of publication may impact on the accuracy of the article.
A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by interest rates at the time you take your benefits.