Updated 07 May 2020
If you have a defined contribution pension, there are a number of ways in which you can use it to fund your retirement. In the past, most people used their pot to buy an annuity (a guaranteed income for life) and this remains a popular option. However, pension drawdown rules allow for a more flexible – if riskier – form of income.
Pension drawdown is a way to take a flexible income from your pension savings. Over your career, you will hopefully have built up pension savings in either workplace pensions or private ones. If these are defined contribution pensions (as opposed to defined benefit) then you will end up with one or more pension pots. You can use the money in your pension pot(s) to support you in retirement. There are several ways to access this money, and drawdown is one of them.
Drawdown allows you to make withdrawals of money from your pension pot. The withdrawals are classed as income (so are subject to tax). You can take as much or as little as you like, within the limits of your pension pot – once your savings are gone, they’re gone.
When you set up a drawdown scheme, the money accumulated in your pension pot is moved into a new set of investments, called a fund. You will draw money out of this fund over the years to come, so the fund itself needs to be set up to try and make your pension savings last as long as possible.
Being invested in assets such as stocks & shares, your fund will rise and fall with the movements of the stock market. This can deliver strong growth, but can also put you at risk of losing money. The blend of investments in your drawdown fund can therefore be crucial – you want a mix of assets that can deliver steady growth over the long term, while being as resilient as possible in the face of stock market dips.
The main upside of drawdown is that you can vary your income. If you need to spend more in a particular year you can increase the amount of money you take. On the other hand, if you have a low-spend year, you can reduce your income and lower your tax bill at the same time.
Another possible benefit of drawdown is that it has the potential to deliver a higher overall income than an annuity. However, the reverse can also be true – see ‘What are the disadvantages of drawdown?’
A significant benefit of drawdown is that you retain ownership of your pension pot (unlike with an annuity, where you surrender the pot). This means that your family can inherit any unspent pension pot when you die, free of tax. This is particularly advantageous for your beneficiaries if you happen to die sooner than expected.
When setting up any pension or drawdown scheme, you must specify the person(s) who will receive any remaining benefits in the event of your death. Any person named in this way is a ‘nominated beneficiary’.
Your nominated beneficiaries will inherit your remaining drawdown fund tax-free if you die before the age of 75. If you die later than that, they will still inherit the fund but must pay income tax on the money they take from it (the tax will be charged at their marginal rate).
The main thing to remember about drawdown is that your pension pot is of a limited size. So unlike an annuity (which pays a guaranteed income for life), a drawdown scheme can run out of money.
Your pension pot can also lose value. The pot remains invested in the stock market, so if the market performs badly, it can shrink even if you don’t take any income. Also, taking money out during a period of low performance makes it much harder for the pot to grow again. Drawdown funds can therefore shrink much faster than expected if the market performs poorly. This makes it hard to judge how long they will last, or how much income you can safely take. It is perfectly possible for drawdown to under-perform annuities.
Finally, because of such risks, a drawdown scheme needs ongoing attention from you and/or your financial adviser – unlike an annuity, which takes care of itself once it’s set up.
Predicting the lifespan of a pension in drawdown is hard to do, because the fund’s rate of growth will change. For example, you cannot say that a fund of £100,000 paying an income of £4,000 a year would last 25 years, because you need to factor in fund growth. If such a fund achieved a steady 4 per cent growth it would almost never run out, because it would earn nearly £4,000 in interest alone. However, in the real world growth is not steady, and any fund shrinkage – especially early on – can shorten the life of your pot.
Ask your financial adviser what level of income they recommend taking from your pot, and try not to exceed this too often. Also try not to make large withdrawals if performance is poor – so monitor your investments regularly.
Choosing to use drawdown should not be a quick decision. Whether or not it suits you will depend on many factors, including your overall finances, your retirement plans, your family situation, your attitude to risk, and the current economic circumstances too. For this reason, no-one should opt for drawdown without first discussing it with an independent financial adviser.
Your adviser will help you decide whether drawdown is best for you, and can also find the most suitable scheme for you from the whole of the market. You may even discuss using drawdown as part of a combined strategy that also includes an annuity, to give a balance of flexibility and security.
Find out more about your options for drawing your pension.
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