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What Is Pension Drawdown? Should I Consider It?

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What is Pension Drawdown?

Pension Drawdown is a way to take your defined contribution pension flexibly at retirement while it remains invested in the markets. You can access your pension via drawdown from the age of 55.

The 2015 pension freedoms introduced fully flexible drawdown — known from 2015 as flexi-access drawdown to reflect its difference from what came before — to the masses. Everyone now has access to drawdown and the full range of associated flexibilities that come with it if they want to make use of it.

You’re free to create your own programme of lump sum payments or invest the pension to generate an income to live off and draw that, or take a mixture of these two approaches. You’re typically entitled to take up to 25% of your pension pot upfront as a tax-free lump sum, known in the jargon as a pension commencement lump sum (PCLS).

You can take the 25% tax-free cash in one go if you decide to designate your whole pension to drawdown. In which case, 25% of the entire pension pot can be withdrawn as tax-free cash. Alternatively, you can opt to move your pension to drawdown gradually, in which case 25% of each sum you move to drawdown will be tax-free.

Once all or part of your pension pot is in drawdown, you can choose how and when to take a retirement income from the drawdown fund.

The April 2015 Pension Freedoms

Prior to April 2015, most people were forced to take their pension via an annuity which, while providing a fixed, guaranteed income for life, had the downside of providing very little flexibility. Another issue with annuities is that annuity rates have been very low for some time, meaning it’s taking an ever-larger pension pot to buy a similar income to those that would have been possible in years gone by.

Annuities were previously a compulsory purchase if you had a pension pot / pension income of less than a certain figure to minimise the risk of those with smaller pension pots or retirement incomes using up all of their retirement savings too quickly and having nothing left to live on in retirement.

Otherwise, if you qualified to not purchase an annuity at retirement then, before April 2015, you could access your pension via two methods of drawdown: capped drawdown or flexible drawdown.

Capped and Flexible Drawdown

Capped drawdown placed a limit on how much you could draw from your pension each year as equal to up to 150% of a comparable lifetime annuity based on tables published by the Government Actuary’s Department.

Flexible drawdown was similar to today’s flexi-access drawdown with the exception that you needed to have at least £12,000 of guaranteed income elsewhere to use it. This limitation has now been removed as of April 2015.

Flexible drawdown has now been replaced with flexi-access drawdown. If you were in flexible drawdown prior to the 2015 pension freedoms, you’ll have been moved to flexi-access drawdown automatically.

If you were in capped drawdown, you have the option to remain in capped drawdown or enter flexi-access drawdown. Moving from capped drawdown to flexi-access drawdown can be achieved by breaching the cap on income permitted under capped drawdown or by applying to transfer your capped drawdown arrangement to flexi-access drawdown.

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How Much Does Drawdown Cost?

As your portfolio remains invested, it will therefore be clocking up fees and charges throughout your retirement. You’ll also be subject to income tax on withdrawals from your drawdown portfolio over and above your tax-free cash.

Management charges come hand-in-hand with other fees, including:

  • Set-up fees
  • Advice charges
  • Annual drawdown and SIPP fees
  • Platform fees
  • Withdrawal fees
  • A whole spectrum of charges for fund and share trading
  • Drawdown-specific charges, such as charges on withdrawals (both tax-free lump sums and income) and charges if you convert your drawdown pot to an annuity.

Some providers will charge all of the above, some won’t charge anything more than an annual management fee. It depends on the provider.

As such, there’s no hard and fast rule on how much pension drawdown costs, but the above can make drawdown an expensive option. This makes it vital to shop around to find the best deal.

The pensions industry hasn’t necessarily made it easy to compare the costs of drawdown contracts thanks to the wide array of different charging structures and fees that are imposed.

Naturally, more complex contracts that might offer a broader range of investment, trading, monitoring or reporting options will tend to be more expensive.

Even so, those researching their own drawdown solutions could encounter a wide array of fees; some providers will impose as many as five separate types of fee while many contracts also impose exit fees if you transfer elsewhere.

It pays to have an expert in your corner when you’re looking for the income drawdown provider for your retirement.

There are so many ins and outs and it’s an important decision that you’ll want to get right.

Jonathan Cooper
Senior Paraplanner at Drewberry

Is Pension Drawdown Right for Me?

Income drawdown is only an option for people in certain defined contribution or money purchase pension schemes. It’s not available to those with final salary pension, as they receive an income direct from their old employer in retirement.

Other pensions that won’t usually allow income drawdown include:

  • Section 226 retirement annuity contracts (RAC) or section 32 buy-out plans
  • Defined contribution occupational schemes
  • Additional voluntary contribution (AVC) and free-standing AVC plans
  • Not all personal or stakeholder pensions offer drawdown.

If your pension doesn’t allow drawdown, it may be possible to transfer your pension to a provider which does. However, think carefully before doing so as a transfer could see you losing guarantees older pensions offered which newer arrangements tend not to have included.

The flexibility of drawdown can seem tempting, but the reality is that it won’t be right for everyone. There are advantages and disadvantages to drawdown to consider that everyone should be aware of before starting to draw down their pension. For instance, note that Income Drawdown isn’t an appropriate option for those who need a regular retirement income.

John Spink Head of Financial Planning at Drewberry

It takes careful, regular planning to ensure that your pension pot won’t run out in your retirement.

In some cases that may mean having to reduce or even stop taking an income from the fund, especially when markets are falling.

John Spink
Head of Financial Planning at Drewberry

Advantages of Pension Income Drawdown

Income Drawdown Leaves Your Pension Invested

For those who built up money purchase (defined contribution) pension savings during their working life, their pension has likely been invested in global markets.

Drawdown allows you to remain invested in this way in retirement and provides continuing flexibility on when you take income and how much you take.

The fact that your retirement savings remain invested means that there’s room for potential investment growth in retirement.

With an annuity, the main alternative to pension drawdown, there’s no room for investment growth in retirement.

Pension Drawdown Offers Greater Flexibility

Flexi-access drawdown arrangements allow you to withdraw lump sum and income payments from your pension as and when they’re needed (subject to the rules on tax).

This means that retirees taking their pension via drawdown can choose to take out different amounts each year depending on their needs.

This is compared to an annuity, which you can’t adjust on a regular basis and will pay you the same fixed income each year.

Reduce Tax on Pension Income

As it’s so flexible, drawdown can enable retirees to manage their annual income to ensure that it remains in the lowest marginal tax band.

By carefully monitoring your total annual income and only taking lump sums or income when it’s really needed, you can ensure that you pay the minimum amount of tax on your retirement income.

Pass on Your Pension More Easily

Those with money purchase arrangements can now pass on any remaining pension wealth to their chosen beneficiaries with a lower tax burden as a result of the pension freedoms. The 55% ‘death tax’ charged on the pensions of deceased pensioners was abolished in April 2015.

An inherited drawdown pension is typically free from inheritance tax because it’s held outside the estate (all the while it remains in the drawdown / pension wrapper and not in another vehicle, such as a savings account).

Moreover, if you pass away before the age of 75, your beneficiaries can inherit the pension pot and continue to draw an income from it all while not having to pay any income tax. If you die after the age of 75, your beneficiaries will have to pay income tax at their highest marginal rate on the pension / income they inherit.

Disadvantages of Income Drawdown

No Guarantee of Income

With Income Drawdown, your pension will remain invested and that will come with all the typical risks of investing, chiefly that the value of your investment could fall as well as rise in line with markets.

If you are unable to take the risk of your retirement income from a drawdown fund falling, then purchasing an annuity is likely to be the best option for you.

Your Pension Pot Could Run Out

Naturally, releasing pension lump sums and regular income payments reduces it in size, especially if investment markets are declining.

If you take too much, too soon from your pension, you live longer than expected, your investments underperform, or a mixture of all three circumstances comes to pass, then your pension fund could run dry before you die, leaving you with no money to live on.

This is opposed to an annuity, which offers you a guaranteed pension income for the rest of your life, no matter how long that might be. Even if you begin to receive in annuity income more than you originally paid for the annuity, the annuity provider still has to continue paying out.

Drawdown Investment Risk

With annuity rates currently very low, many people are attracted to drawdown as a way to maximise pension income. However, it’s important to realise that an annuity offers a guaranteed income and the assurance that no investment performance is required in order for it to pay out.

To more cautious investors this may still be more attractive than taking on the added risk that comes with drawdown.

Drawdown is More Complex Than an Annuity

Compared to making a one-off purchase of an annuity, drawdown is a complex process. As well as requiring retirees to shoulder the investment risks, it also requires regular reviews and planning.

Drawdown Could Be More Expensive

There are a variety of fees and charges involved with drawdown, from annual management charges to fees for withdrawing your pension cash.

With an annuity there’s usually a fee for the initial setup, which can be taken from your pension pot, but few if any fees to consider thereafter. Drawdown, on the other hand, comes with an array of ongoing fees and charges that could eat into your pension pot.

The Money Purchase Annual Allowance

The Money Purchase Annual Allowance (MPAA) is a reduction in your annual pension allowance that comes into play once you’ve started flexibly accessing your pension.

Your annual pension allowance refers to how much you can pay into your pension and still receive tax relief in any given tax year. It’s limited to £40,000 per tax year or 100% of your earnings, whichever is lower.

However, once you start flexibly accessing your pension via drawdown — i.e. you start taking more than your 25% tax-free cash — this allowance is slashed to £4,000 per tax year.

With the chief risk of pension drawdown being that your money will run out too soon in retirement, one way to help mitigate this is to use a tool such as our Pension Drawdown Calculator below to work out how long your pension will last depending on the income you take.

Pension Drawdown Calculator

When will your income drawdown pension run out? Enter the anticipated size of your pension pot at retirement and follow these easy steps to calculate how long your pension will last.

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Alternatives to Pension Drawdown

You don’t have to opt for pension drawdown at retirement.

Although its flexibilities may seem tempting to many, that doesn’t mean it’s the right option for you. It’s not the only option on the market for taking your pension income.

Annuities

With an annuity, you exchange all or part of your pension pot for a guaranteed income for the rest of your life. You can opt to index-link this to inflation so that your spending power in retirement won’t be eroded over time.

You’re still entitled to take up to 25% of your pension upfront as a tax-free cash lump sum before buying an annuity, although the larger the lump sum you take clearly the less will be available to buy a pension income.

You can buy an annuity after using drawdown to access your pension flexibly if you wish, or purchase one straight away at retirement. However, once you’ve bought an annuity it’s an irreversible process. You can’t unpick the contract, get a refund and go back to drawdown. So think carefully before deciding on an annuity as your retirement income stream.

An annuity provides a fixed, guaranteed income each year for life. This is a taxable income, and there’s no way to adjust it should you want to reduce your income one year for tax purposes.

The upsides of an annuity include the fact that the pension will never run out, no matter how long you live. This is opposed to drawdown, where there is a risk your pension could run out in retirement.

Unfortunately, one of the downsides of annuities is that rates are currently very low due to underlying economic factors, so it’s taking larger pension pots to buy a similar income than was possible in the past. This means annuities can seem an expensive way of providing a retirement income.

Uncrystallised Funds Pension Lump Sums (UFPLS)

Another alternative to drawdown is taking lump sums direct from your pension pot without the intermediary step of moving it to a drawdown fund. This is known as taking uncrystallised funds pension lump sums (UFPLS). Even in acronym form this is a bit unwieldy, so it’s sometimes referred to as taking a ‘FLUMP’.

You can only opt for UFPLS if you’ve not already taken any tax-free cash or income from your fund.

These funds are referred to as ‘uncrystallised’ because you haven’t moved the money out of your pension pot and designated it to income drawdown or the purchase of an annuity.

Essentially, you treat your pension savings a little bit like a bank account, drawing funds as and when you need to. All throughout retirement, the remainder of your pension that you haven’t withdrawn remains invested and therefore has the potential to continue to grow.

When you take a UFPLS from your pension, the first 25% of any withdrawal is tax-free. The rest incurs income tax at your highest marginal rate.

How is Income Drawdown Taxed?

How pension drawdown is taxed depends on exactly how you access your pension, as well as how much of it you access and when.

You have two main options for drawdown, as well as taking your pension through a series of uncrystallised funds pension lump sums:

  • Withdraw your 25% tax-free cash and allocate the remaining 75% to drawdown
    25% will be free from tax and the remainder will be taxed as income when you take it.
  • Take just some of your tax-free lump sum
    You can take a proportion of your 25% tax-free allowance, providing a sum worth three times the tax-free total is moved to drawdown to preserve the mandatory 25% tax-free / 75% taxable split. The rest of your pension remains invested and uncrystallised, with the option to take further lump sums in the future on the same terms.
  • Take an uncrystallised funds pension lump sum (UFPLS)
    Rather than moving your pension pot to drawdown, you can withdraw cash lump sums (the first 25% of which are tax-free and the remaining 75% taxable) direct from your pot.

How Much Tax Will I Pay if I Move My Entire Pension to Drawdown?

If you decide to designate your entire pension pot to drawdown at once in a single tax year, 25% will be available as a tax-free cash lump sum.

The remainder will be moved to a drawdown fund and taxed as income in the year you choose to take it.

Once the 75% of your pension is in flexi-access drawdown you can take cash lump sums out of your pension or invest it to provide an income. You can also use a mixture of the two. These will be taxable in the year you take them by being added to your other income, including the State Pension, to work out the tax you should pay.

While it’s possible to take just the 25% tax-free cash lump sum and leave the remainder of your pension invested, you can’t do so without moving the remaining 75% to a drawdown fund, even if you don’t want to touch the rest of your pension just yet. Fortunately, once that 75% is in an appropriate drawdown arrangement, you don’t have to touch it straight away — you can leave it invested and take an income from when it’s required.

Do I Have to Move My Entire Pension to Drawdown?

No, you don’t have to move your entire pension pot to drawdown all at once.

Phased or gradual income drawdown sees you slowly shift your pension pot into drawdown over time.

How Drawdown is Taxed: Phased Withdrawals

Every time you withdraw cash from your pension via phased income drawdown you take just some of the 25% pension commencement lump sum you’re entitled to.

Each time you designate a chunk of cash to drawdown, the first 25% is tax-free. The cash you leave behind stays invested with your pension provider.

For example, say you have a total pension of £100,000. You’re entitled to take up to 25% of your pension upfront as a tax-free cash lump sum, equivalent to £25,000.

However, if you only need some of that tax-free cash, say £10,000, you can opt to take just the £10,000 providing you move an additional £30,000 from your pension to your drawdown fund to maintain the 25% tax-free / 75% taxable split.

This leaves you with £60,000 still invested in your pension fund, £10,000 of tax-free cash, and £30,000 in a drawdown fund that you can take lump sums or income from as you see fit at a later date. Anything you draw from this £30,000 in drawdown will be taxable at your highest marginal rate.

Tax on Uncrystallised Funds Pension Lump Sums

When it comes to uncrystallised funds pension lump sums (UFPLS), you withdraw money directly from your pension pot without the intermediary step of moving it to drawdown first.

Here, each time you take a UFPLS, 25% of the sum you take is tax-free and 75% is taxable as income.

Imagine you have a £100,000 pension pot and you decide to take a FLUMP worth £10,000 out of your pension. 25% of this sum — £2,500 — will be free from tax. The remaining £7,500 will be added to any other income you have that year and may therefore incur income tax depending on your other earnings.

You are left with £90,000 in your pension pot which you can withdraw at a later date.

Taking lump sums from your pension will reduce its capital value. If you continue to do so, especially when markets are falling, you are at an increased risk of your pension running dry early. You must carefully manage lump sum withdrawals to prevent this from happening or, better yet, engage an adviser to monitor this risk for you.

How Inherited Drawdown Pensions Are Taxed

The two main taxes people are worried about if they pass away with funds in drawdown are inheritance tax and income tax for their beneficiaries.

Pensions lie outside of your estate, so drawdown savings are not normally subject to inheritance tax (IHT). This assumes the pension remains invested in a pension and / or drawdown fund and hasn’t been withdrawn and placed in another vehicle, such as a savings account, that would be subject to inheritance tax.

If you die before age 75, all your pension assets can be passed to your beneficiaries free of tax.

They can choose to continue drawdown — a process called nominee drawdown — and enjoy the income tax free or they can purchase an annuity, the income from which will also be free of tax. They don’t need to be 55 to access an inherited pension either.

Currently, if you die after age 75, your beneficiaries will be liable to income tax at their marginal rate on anything you might leave them. They will pay tax on any income if they choose to continue with drawdown and the income from any annuity they might purchase will also be taxed at their marginal rate.

Even if the original pensioner dies before the age of 75, cash lump sums, annuities and drawdown income paid from an inherited drawdown pension pot are only tax-free if they’re paid within 2 years of the individual’s death.

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