What is pension drawdown and how does it work?

Pension drawdown is one way of taking money from your pension pot.

This guide tells you everything you need to know about pension drawdown, including the fees involved and tax implications so that you can choose the right provider for you.

Ready for drawdown? Our pick of best pension drawdown providers can help you choose.

We outline:

• What is pension drawdown?
• Is pension drawdown a good idea?
• Taking income from my pension in drawdown
• How is my pension taxed in drawdown?
• Pension drawdown investments

What is pension drawdown?

Pension drawdown, also known as income drawdown or flexi-access drawdown, is a flexible way of taking cash out of your pension savings.

Rather than buying an annuity, savers can move their pension savings into a drawdown product, which lets them take income when they need it.

Savers have had this option since April 2015 when the pension freedom rules were introduced.

Each time you move your money from your pension savings into drawdown, 25% of it is tax-free.

Remember: you can move your pension savings into drawdown gradually which is known as “partial drawdown”. This allows you to keep taking advantage of the 25% tax-free perk.

How pension drawdown works

You can either set up a pension drawdown arrangement with your current provider or you might need to transfer your savings to a different provider.

Bear in mind that you can only use income drawdown for defined contribution pensions. This includes:

• Self-invested personal pensions (SIPPs)
• Modern workplace schemes

If you have a defined benefit pension (also known as a final salary pension), you won’t be able to use drawdown.

For more information on different types of pensions, see our pensions guide.

The main alternative to drawdown is an annuity. This is an insurance product that pays a fixed income for the rest of your life in exchange for your pension savings.

Find out: Should I go for an annuity or drawdown?

Is pension drawdown a good idea?

There is no easy answer to this because it depends on your individual circumstances.

Make sure you understand what you would get from buying an annuity so you can compare your options. You might want to read: Should I go for an annuity or drawdown?

Pros

• Drawdown is the most flexible option, allowing you to take income as and when you like
• You can choose how your funds are invested during retirement
• You want to pass your retirement savings to your loved ones when you die without paying an inheritance tax.
• If you die before the age of 75, your beneficiaries also won’t have to pay income tax on the pension fund they receive. 

Cons

In an ideal world, your investments do well, and your income gets bigger each year. But with drawdown, there is no guarantee your pension funds will last for the rest of your life.

One of the major disadvantages of drawdown is that you could run out of money during retirement. This can happen if:

• Your investments don’t do very well
• You take too much money too soon

This is different to an annuity which can give you a secure income for life but is less flexible. Find out: Should I go for an annuity or drawdown?

In practice, taking income when in pension drawdown is a juggling act.

You have to balance between taking enough cash for a comfortable retirement and keeping enough invested so the remaining pension doesn’t run out before you do.

Read more: ‘How do I use pension drawdown to access tax-free cash?’

Drawdown might make sense if you…

• Prefer to keep at least some of your money invested
• Want to have more control over where and how it is invested
• Don’t need your pension to provide you with a regular income because you have income from other sources, such as buy-to-let properties

If you decide to opt for drawdown, make sure you won’t sacrifice any valuable benefits by transferring.

Consider talking to a financial adviser about whether drawdown is right for you, and how to put it into practice. Paying for financial advice could help avoid a financial car crash.

How do I arrange my pension drawdown?

Your pension provider might offer a drawdown facility, so would be able to convert your savings for you. You should contact your provider in the first instance to check if it offers this.

While a SIPP or personal pension may make this function available, not all workplace schemes do.

If your pension provider does offer drawdown, make sure you research the plan properly and understand any fees.

But if your pension provider doesn’t offer a drawdown arrangement, you might need to transfer to a new pension company or investment platform.

Sticking with the same provider that you’ve built up your pension with may be easier, but moving to a competitor could save you money and offer more investment choice.

But make sure you research the market to find the right product for you. Find out why Vanguard has been given five stars in our independent ratings

You then have the freedom to take the cash out as you please. The flexibility allows you to take less income if you are still working, or take higher payments until your state pension kicks in.

Can you drawdown a defined benefit pension?

The simple answer is no. You would have to transfer your defined benefit pension into a defined contribution pension if you wanted the flexibility of drawdown.

When it comes to transferring a defined benefit pension, things get far more complicated.

A defined benefit pension pays you an income for the rest of your life, which is why they are often called “gold-plated schemes”.

It might be possible to transfer your defined benefit pension into a defined contribution scheme with help from a financial adviser.

However, transferring out of a defined benefit scheme is not in the best interests of the vast majority of savers.

Transferring out of a gold-plated pension scheme means you would be sacrificing valuable benefits.

For this reason, you might find that many financial advisers will not recommend transferring out.

• Find out: How much does financial advice cost – and is it worth it?

Taking income from my pension in drawdown

After celebrating your 55th birthday, you can think about accessing your pension.

Make sure you consider the implications of taking money from your pension pot. You don’t want to run out of money in your later years so accessing it as early as 55 might be a bad idea.

Also bear in mind that once you start taking an income from your pension, you are limited in how much you can contribute into your pension each month.

How much income can you take?

The main advantage of pension drawdown is that you can take income flexibility.

So you can decide you only need an income of £10,000 one year and £20,000 the next.

If you choose to move into income drawdown, many people decide to:

• Take 25% of their entire pension as a tax-free lump sum
• They then move the remaining pension of 75% into a separate drawdown account. Any future withdrawals from this drawdown account will then be taxed as income

However, you don’t have to do this and can opt for what’s known as a partial drawdown. This is where you move your pension pot gradually into income drawdown.

Each time you take a chunk from your pension, 25% is tax-free while the rest will be in the drawdown account to be taxed at your marginal rate.

It is usually better to withdraw your pension income in small chunks rather than crystallise the whole pot in one go. This means you can continually take advantage of the tax-free lump sum and it makes your pension stretch further.

We explain more in chapter seven of our pensions guide.

What is the 4% retirement rule?

One rule of thumb to preserve your pension pot is to take 4% of your fund as income in the first year, and then increase that amount by inflation in each future year.

The 4% rule is used by followers of the Fire saver movement.

Another approach is to stick to withdrawing the “natural yield”, which is the dividends and returns produced by your investments, without having to cash in the investments themselves.

This way you will still have the actual pension pot to either tap into at a later date if you need a big cash injection, such as for a new car or home renovations.

You might want to speak to a financial adviser if you’re unsure of what to do.

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How is my pension taxed in drawdown?

Klaxon alert: money you take out of your pension can be taxed.

Pensions and tax is a tricky topic, but here are the highlights you really need to know.

We answer a reader’s question: How do I use pension drawdown to access tax-free cash?

How much can I drawdown from my pension without paying tax?

Only the first 25% of the money you “crystallise” from your pension pot is tax-free.

Take out any extra money from your pension, and the money is added to any other earnings for the year and is treated as taxable income.

So if you take out a large chunk, it could push you into a higher tax band leading to a bigger tax bill.

For example:

• Let’s assume you took your 25% tax-free cash when you went into drawdown.
  
• You are usually a basic-rate taxpayer but you decide to take £5,000 from your pension
  
• This takes your total income to £52,500, this means you have tipped over the higher-rate threshold (£50,270 for 2022/23 tax year).
  
• So, £2,230 of the pension withdrawal will be taxed at the higher rate, which is 40%.
  
• Yet if you took out £1,000 a year for five years, to stay below the higher-rate tax threshold, you would pay only 20% tax and hang on to more of your own money to give you a healthier retirement income.

When you make a withdrawal, your pension provider will take off any income tax first, and may put you on an emergency tax code.

In theory, HM Revenue & Customs will refund any overpayment when you submit your tax return – or charge extra if you haven’t paid enough tax. Alternatively, you could claim a tax refund earlier.

Pension contributions and the money purchase annual allowance

The other caveat about withdrawing large sums is it can affect how much you pay into a pension in future.

This can be important if you intend to continue working and contributing to a pension after age 55.

Once you start taking income from your pension, the MPAA kicks in, which stands for money purchase annual allowance.

The MPAA means you can only pay £4,000 into your pension and still benefit from tax relief.

That’s a drastic reduction because most people can contribute up to £40,000 a year into their pension and benefit from tax relief (known as the annual allowance).

Tax on pensions after you die

The good news for your nearest and dearest is that any money left in your pension pot when you die will not be subject to inheritance tax.

Instead:

• If you die before 75, your beneficiaries can take tax free cash, provided they withdraw it within two years.
• If you die after 75, the person who inherits your pension will pay tax on withdrawals at their highest income tax rate.

This can be a good reason for spending other savings before plundering your pension pot.

Find out more in our guide to inheritance tax.

Pension drawdown investments

A big advantage of drawdown is the chance to leave the bulk of your pension fund invested in the hope it will grow and provide a higher income in the future.

However, investments can fall as well as rise, so it’s not a guaranteed income for life.

Your choice of investments will depend on how much income you want to take, your age and how much loss you are willing to risk.

• Stock market investments, also known as shares or equities, provide the potential for higher growth – but also for bigger losses.
• Meanwhile more cautious bonds and cash may stop your balance falling too far but won’t grow as much either.
• Mixing in other types of investment, such as commercial property and commodities like gold or wheat, can help keep your balance from bouncing up and down.

You need to estimate how long you might live in retirement. If your money needs to last for 20, 30 or more years, it’s sensible to keep some money invested in shares.

This is because it has more chance of beating inflation than lower-risk, low growth bonds.

The main message is:

• Don’t put all your eggs in one basket, as you don’t want to run out of money.
• Spread your investments across a mix of different assets, countries and companies helps balance between growth and the chance of losing money.
• Pay attention to fees as expensive investment charges can really eat away at your retirement savings.

If picking all the investments yourself sounds baffling, remember that some drawdown providers offer ready-made portfolios or you can pay a financial adviser to create the right mix for you.

Find out more in our beginner’s guide to investing.

Reviewing your pension in drawdown

Pension drawdown is a moving target: investments go up and down and income will be flowing out.

So you can’t just decide everything on day one and then forget about it.

It’s important to review your pension at least once a year, to check how your investments are doing.

You may need to “rebalance” your portfolio by:

• Selling some investments and buying others to keep the same level of risk.
• Reviewing how much income you take
• Switch investments to deliver income

Again, you can choose to do this yourself, or pay a financial adviser to do it.

How to choose the best pension drawdown provider

Remember that you do not have to use the same provider for drawdown as the one where you built up your pension savings.

You can move your money elsewhere. But check first you are not giving up any valuable benefits, such as:

• Tax-free cash larger than 25% of your pension
• Or generous guaranteed income levels

Our pension quiz might be helpful to understand whether transferring is a good idea.

To use drawdown, you may need to move your money into a SIPP. Our guide to SIPPs explains more.

Drawdown providers all offer different flexibility and choice – and they certainly charge different amounts.

Before you go shopping for your perfect drawdown partner, here are four key things to look out for:

1. Choice of investments

Weigh up whether you would like the choice of gazillions of shares, funds and exotic assets, or would be happy with a more limited choice. 

2. Flexibility when taking income

Some providers may make it difficult and more expensive if you want to change how much income you take.

3. Costs

When investing over decades, those tiny percentage fees really add up. Drawdown charges can be bewilderingly complex to compare, but the main costs include:

• Set-up fees
• Administration charges
• Platform charges
• Dealing costs when trading investments
• Fees on the investments themselves

Charges expressed as a percentage of your pension may make sense on smaller pots, but flat fees may be cheaper if you have a larger amount.

Hefty exit fees can also be painful if you decide to move your money later.

 4. Customer service

The cheapest provider may only offer a bare bones website. So consider whether you might benefit from paying a bit more for extra tools, investment information, research and a helpful customer support team.

What is the best drawdown pension?

Vanguard scored top marks in our independent ratings because its charges are really low, while Aviva did well for customer service. You can find out more in our list of the best pension drawdown providers

Getting advice on pension drawdown

If you want expert help, once you reach 50 you can book a free appointment for guidance from the government service Pension Wise.

However, Pension Wise will not tell you which specific drawdown provider or investments to choose.

A financial adviser can help decide if drawdown is right for you, work out which investments and provider to choose, and what level of income to take.

Advisers are not allowed to get commission, so you are likely to face either a flat fee or a fee depending on their time. You may be able to pay the fees out of your pension funds.

Find out more: How much does financial advice cost – and is it worth it?

If you then want the financial adviser to monitor your pension funds and provide advice in future, expect to pay a fee based on a percentage of your pension pot.

Track down local independent financial advisers through Unbiased.co.uk*or VouchedFor.co.uk.

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