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What is pension drawdown?
Telegraph Money explains how to manage your pot through flexi-access drawdown without letting it run out
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Accessing your pension pot is a big moment after years of making contributions, but the way you withdraw your hard-earned retirement savings can have a big impact on your golden years.
Traditionally, many retirees would use their pension pot to purchase an annuity, which provides a fixed income for life during retirement.
But following the introduction of pension freedom rules in 2015, there are now other ways to access and withdraw funds from your pension more flexibly using “drawdown”.
Flexi-access drawdown provides the freedom to increase or decrease withdrawals as your expenses and lifestyle changes, but you need to be careful as there is also a risk of your pension pot running out sooner than expected.
Here, Telegraph Money explains the pension drawdown rules to help you ensure you can adequately fund your retirement without running out of money.
What is pension drawdown?
The two main options to access your retirement savings are purchasing an annuity or using pension drawdown.
An annuity provides a fixed level of income for life that can’t be changed.
This can provide more certainty in that you’re guaranteed income regardless of how long you live, but it can cause problems if you find your expenses suddenly rise, or the rate you get isn’t very generous.
In comparison, with pension or flexi-access drawdown, you can draw money from your retirement savings while the rest of the pot stays invested.
It can give you more flexibility over how and when you receive your pension, letting you increase or decrease your withdrawals as and when you need the money.
How does it work?
An income drawdown pension lets you withdraw as much or as little retirement income as you wish.
It is typically used for defined contribution schemes, rather than a defined benefit policy that pays a fixed annual income for life, linked to your final or average salary.
Once you access your pension, it is moved into an “income drawdown” account.
Your existing pension provider will likely offer a drawdown account, but different firms offer different levels of flexibility, so it is worth shopping around.
For example, some providers may only support taking occasional withdrawals, rather than setting up regular payments.
You can still take 25pc of the pot as a tax-free lump sum, either in one go or across several withdrawals.
Once the tax-free sum has been taken, savers will have six months to start taking the remaining 75pc.
Further withdrawals are then taxed at the retirees’ marginal tax rate.
There are a few options for the rest of the pension pot. It can be left invested so you gain from a rise in the stock market – although this will leave you open to the risks of a downturn and your fund could get depleted, affecting how much you can withdraw.
This means it is worth considering how the remaining pot is invested.
While younger pension savers, who have many years to recover from a market downturn, are able to take more risk with their pots, those nearer retirement should typically take less risk. Pension pots can also be invested in bonds to generate a fixed income, or even left in cash.
To find out how long your pot will last, use the Telegraph Money pension drawdown calculator.
Am I eligible?
A pension pot can currently be accessed from age 55 – rising to 57 in 2028.
So if you have a defined contribution pension then you are likely to be eligible for pension drawdown.
It can often be offered through your workplace scheme or through a self-invested personal pension.
But check what options your provider offers as it may be worth switching if you aren’t getting the flexibility you need.
Types of pension drawdown
There used to be two types of drawdown before pension freedom rules were introduced in 2015.
Previously, retirees had the choice of capped drawdown, limited to 150pc of the government actuary department limit each year, or flexi-access drawdown subject to minimum income requirements.
But these caps and limits were scrapped under the pension freedom rules so now there is no limit on how much can be withdrawn from a pension.
How much drawdown should I take?
Deciding how much drawdown to take is a big decision.
Your retirement could last at least 30 years or more, so you need to ensure the money doesn’t run out.
It may be tempting to splash out on a world cruise or a Lamborghini – as then-pensions minister Steve Webb suggested when the pension freedom reforms were first introduced – but later in life there may be factors such as care fees to consider.
This means you need to consider how much you take so the pot doesn’t run out, and also how the remaining fund is invested so it can grow effectively.
“The first thing is to work out how much you think you will need each year for the rest of your life,” said Joshua Gerstler, chartered financial planner at The Orchard Financial Practice.
“It is impossible to know for sure, so what you can work out is how much your life is costing at the moment and any likely changes to this in the future. “
You may find that all your outgoings are already covered by, for example, your state pension and if you have rental income from a buy-to-let portfolio.
“If this is the case, then you may decide not to take anything from your drawdown pension, as this can be passed on to your beneficiaries without any inheritance tax,” he added.
There are a few schools of thought on withdrawal strategies.
The 4pc rule
One rule of thumb suggests a safe withdrawal level is 4pc. Becky O’Connor of Pension Bee says: “The 4pc rule is a handy tool to work out what you might need, roughly, in your pot when you retire to be able to afford the living standard you want.
“It’s what you should, all things being equal, be able to take out of your pot each year for it to last your whole retirement.”
Calculations by stockbroker Hargreaves Lansdown show that someone aged 65 taking 4pc per year (after their tax-free cash) from a £100,000 pension would have approximately £35,000 left in their pot if they lived to age 88, if their investments returned an average of 5pc per year.
However, if you only had investment growth of 2pc over that time then you would see your fund depleted by the time you hit age 86. And if global economic conditions are rough for a while, you need to be prepared to react to changes in the market environment.
Helen Morrissey, head of retirement analysis at Hargreaves Lansdown, said: “Markets go up and down and if you don’t amend your withdrawal strategy accordingly then you could find yourself running out of money more quickly than you first thought.
“This is particularly the case if you experience big market drops early in your retirement – if you don’t keep a close eye on how much income you are taking you could find your fund depleted and need to make some tough decisions later on in retirement about how much income you can take.”
Ms O’Connor added: “If the markets wobble, then 3pc might be more prudent. On the flip side, if your investments are growing well, 5pc might be possible.”
Taking the ‘natural yield’
If your goal is not just about income but perhaps leaving some of your savings to beneficiaries perhaps, you might prefer another strategy aimed at preserving the value of the pot.
This is known as taking the natural yield – the amount of income your pension investments generate every year from dividends from shares or interest from bonds – leaving the capital untouched.
Ms O’Connor said: “This natural yield might end up being roughly 4pc anyway, depending on what the dividend income produced by your investments is every year.”
In good years, this strategy would allow you to take more income and in poor years, you would have to get by on less, if you want to preserve your pension’s value.
This strategy relies on having a heavy weighting towards stocks that pay dividends over those, such as fast-growing technology companies, that generally to not make payments to shareholders.
The verdict
To work out what strategy is best for you, you’ll need to know a bit about what your pension pot is actually invested in and whether it is producing dividend income from the shares held or interest from any bonds.
Ms O’Connor said: “A pot with a lot of healthy dividend-paying shares might generate enough natural yield to keep you and your pot going throughout retirement in an ideal world. But dividends vary from year to year and so does interest.
“You might also still have a significant portion of your pot invested in equities for growth, which should increase your capital balance over time, but will also limit the proportion of your pot generating natural yield.
“You might have to alter which strategy you are using for income based on economic conditions, too, to optimise your pot and make it as sustainable as possible.”
You’ll ideally review the amount you take annually to check if any changes need to be made. Perhaps if the rate of inflation changes, you might need more – or less – income. Or if there’s a market shock and share prices drop you might want to adjust your strategy.
If you’re not confident in making these kinds of decisions yourself, you can enlist the help of a financial adviser who can help set withdrawals levels and flag any big market changes that require any adjustment to your income or to the way your money is invested.
However, advisers don’t come cheap. They typically charge an initial fee and an ongoing fee.
The latest data available from the Financial Conduct Authority (FCA) says just a third of people who accessed income drawdown plans for the first time in 2021-22 took professional advice.
When should I take it?
You can begin drawing down on your pension at 55, but accessing your pot too soon could cost you thousands.
Analysis by pension firm Aegon for Telegraph Money suggested that someone with a £400,000 pension pot would be £24,618 worse off after five years if they took their 25pc lump sum too soon.
Assuming an investment return of 4.5pc a year, the £100,000 would generate returns of £24,618 over five years if left invested.
Steven Cameron, pensions director at provider Aegon, said: “Some individuals are keen to get their hands on the tax-free lump sum even if they don’t actually need any income from the balance.
“But if you have no plans to spend this, and left it sitting in the bank, you could be losing out.”
The timing of withdrawals, inflation and subsequent investment performance can make a big difference to the longevity of your pension pot.
Analysis by Lumin Wealth for Telegraph Money, based on taking £50,000 out of a £1.5m pot annually and increasing it by 2pc to allow for inflation each year, shows an investment return of 5pc could mean the pot lasts more than a decade longer compared with a 2pc return.
This underlines the importance of planning how much you withdraw and keeping an eye on how the remaining pot is performing.
Joe Fisher, financial planning manager at Lumin Wealth, said: “Large negative returns early on in retirement, combined with withdrawals, can eat into the value of a portfolio. If not managed correctly, it can lead to funds not lasting the full duration of retirement, or a retiree being unable to live the lifestyle they had previously envisaged.”
Samuel Mather Holgate, an independent financial adviser for Mather and Murray Financial, said many clients split their drawdown account in two based on what they require for the next five years, which is retained in low risk assets, while the remainder is in a growth fund.
“The amount of income they take will be determined my market conditions over the preceding five years,” he added.
“Some clients start by using the 4pc rule, but this is a crude measure of sustainability and investments and income need to be reviewed regularly. Fixed term annuities are playing a role in some drawdown plans, as clients look to hedge the higher than normal rates currently available.”
Other considerations
There is plenty to consider beyond just when and how you use income drawdown such as tax and fees.
Do you pay tax on pension drawdown income?
While you can take 25pc of your pension tax-free, any further withdrawals will be taxed at your marginal rate – that is, the highest rate of tax your income falls under.
For example, if you take a regular income that gives you £18,000 a year as your sole income, you would pay tax on your pension withdrawals at a rate of 20pc.
Based on a personal allowance of £12,570, you’ll pay the 20pc tax on only £5,430, rather than £18,000, according to analysis by Standard Life, giving you a bill of £1,086 in tax, which would normally be deducted automatically by your pension provider.
The tax owed could be higher if you receive state pension payments, and other income such as from rent or other investments.
If you are only taking one-off withdrawals, there is a risk that you could pay too much tax.
This is because HMRC applies an “emergency” rate, and will assume you’ll receive the same amount of income each month for the rest of the tax year. In this situation you may have to complete a P55 form to get a refund on the tax paid.
You also have to consider if withdrawals combined with any other income could push you into a higher tax bracket, in which case it may be worth spreading out the money.
What other fees and charges are there?
There are costs associated with drawing down from a private pension, and charges will vary from provider to provider.
Charges can include set-up fees, annual administration and platform charges. There could also be various investment charges if you change your investments.
While some companies charge flat annual fees, others use percentage-based calculations for their charges.
Some also have tapered charges, with the charge dropping or increasing above a certain pot value.
A 2022 Which? investigation found that the difference between the most and least expensive schemes for a £260,000 pot was nearly £18,000 over a 20-year period. That illustrates why it is vital to shop around before committing to a drawdown scheme.
Can you carry on paying into your pension?
You can continue making pension contributions when in drawdown, but the annual limit drops from £60,000 (or 100pc of your income, whichever is lower) to £10,000, known as the money purchase annual allowance.
Contributions will also still receive pension tax relief until you hit age 75, so it is worth staying invested and putting money into your pension, even if you retire early.
Drawdown pension vs annuity
A drawdown fund is flexible, meaning you can take more or less income each year depending on your needs, but future income is not guaranteed.
An annuity, by contrast, guarantees an income for an agreed period of time, often the lifetime of the policyholder. Sometimes this income will increase in line with inflation.
There are several types of annuity, including lifetime annuities, which pay for the rest of your life, or fixed-term annuities which pay for between one and 40 years. The former will likely be more suitable for retirees, but there may be reasons for opting for a fixed period.
Those with health issues that may limit life expectancy may be eligible for an enhanced annuity to help with medical and end-of-life costs.
Annuity rates typically represent the value of the income that will be received each year. For example, if the rate is 5pc, then for each £100,000 paid in at the beginning of the annuity, the saver will receive £5,000 each year.
Rates are calculated using life expectancy, the retiree’s health, interest rates and gilt yields, as annuities are partially funded using government bonds.
The risk of an annuity is that if the retiree dies earlier than expected, they may not have received as much income as they paid in. However, if they live for a long time, they could receive more than their pension pot was originally worth.
Drawdown schemes typically offer pensioners more control over their finances and are popular among higher net worth individuals, as pots can continue to grow.
Another factor to consider is inheritance. Your loved ones won’t have to pay inheritance tax on a pension pot, and if you die before age 75 then whoever inherits the fund can access the money free of income tax.
In contrast, annuity payments disappear once you pass away unless you have a joint life product with your partner.
Is a drawdown pension right for me?
Pension drawdown gives you more control of your retirement savings and lets you adapt your income as your lifestyle changes.
You can also benefit from further market growth by remaining invested.
But there are risks that you need to prepare for. Your portfolio could drop in value, depending how the remaining pot is invested.
Additionally, you need to be willing and able to plan your withdrawals carefully – either yourself or with a financial adviser – so that the money lasts alongside other income and assets throughout your golden years.