When (and how) to drawdown your private pension

Whatever your retirement dreams, when you walk out of the office for the final time it can be tempting to splurge and make the most of it.

But with retirement lasting longer than ever, it is even more important to work out how best to maximise your hard-earned pension savings, built up over decades of work. 

Average life expectancy in the UK is currently around 81 years, so a pension taken at 55 would have to last for more than a quarter of a century.

Choosing how, and when, to access it could have implications further down the line. And while it can be tempting to cash in as soon as possible – especially if you’re planning a project, like improving your home, or you want to help your grandchildren onto the property ladder – planning carefully is the best policy.

There are a large range of options, from ad-hoc withdrawals to an annuity, or claiming 25pc as a lump sum free from tax.

Telegraph Money explains those options and provides the information you need when planning out your retirement.

What is a private pension drawdown?

Put simply, drawing down from a pension means taking money out of your pension pot. You can begin to do this at any point from the age of 55 – although this will increase to 57 in 2028.

Doing this is known as pension drawdown or a flexible retirement income. According to MoneyHelper, it can give you more flexibility over how and when you receive your pension.

How does a pension drawdown work? 

Once you have accessed your pension it is moved into what is known as an “income drawdown” account. It is still possible to make contributions but the amount you can save each year without incurring a tax charge falls from £60,000 to £10,000.

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 savers with a defined contribution pension, you will be able to access 25pc of your pot as a tax-free lump sum – this can be taken 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. 

Those with defined benefit pensions, also known as final salary schemes, will have to check their individual policy rules to see how much tax-free cash they will be able to claim. 

There are a few options for the rest of the pension pot. It can be left invested, although this will leave you open to the risks of the market. 

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 take less risk. Pension pots can also be invested in bonds or even left in cash.

Further withdrawals are taxed at the retiree’s marginal rate.

How much income should I take?

The golden rule for drawdowns, generally used by experts, is to take no more than 4pc of your pot per year. This is to try to ensure you do not run out of money.

It is also possible to take some of your pension income and leave the rest invested where it is while retaining the ability to take further lump sums, whenever necessary. 

Savers can also choose to draw down their entire pension pot in one fell swoop, although those who choose to do this should be aware of the potential tax implications. Unless your pot is very small then it would lead to a hefty tax charge.

Another option is to purchase an annuity, which pays a guaranteed income for life.

When should I drawdown my private pension? 

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 take 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.

If the sum were placed in an easy-access savings account at 2.7pc, close to the average current offering, over the same five-year period, it would earn around half of that: £12,327.

Steven Cameron, pensions director at provider Aegon, warned that retirees should not be too hasty in starting to drawdown – and should consider whether they really need the 25pc lump sum. 

“Just because you can take this lump sum from as early as age 55, doesn’t mean you should and indeed there are many good reasons for not taking it until you actually have a purpose in mind for using it,” he said. 

“There can be many tax considerations too, especially if you are still working and earning an income and considering also starting to take an income from your pension.”

Jamie Sexton, of financial advice firm True Potential, said a flexible approach might work better for many savers. 

“A lot of people take the full 25pc when they reach 55 but they then often leave it sitting in a savings account for a few years, generating little to no growth,” he added.

“For many, a better approach could be to withdraw your 25pc allowance in instalments as part of a flexi-access pension.” 

Drew Nutsford of investment manager Waverton, said savers who didn’t need to take the lump sum upfront could reap a larger tax benefit later if their pot continued to grow. 

He said: “This option has several benefits, as should your pension value continue to increase, the monetary amount of your tax-free cash entitlement can also increase.”

What fees and charges will I pay for a pension drawdown? 

There are costs associated with drawing down from a private pension and charges will vary from provider to provider.  

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. Hence, it is vital to shop around before committing to a drawdown scheme. 

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.

What is the difference between a drawdown and an 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. 

However, drawdown schemes typically offer pensioners more control over their finances and are popular among higher net worth individuals as pots can continue to grow. 

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.

What are the risks of a pension drawdown?

The risk of drawing down on your pension is that you fail to plan ahead and take too much from your pension pot early in retirement. This could lead to you running out of money when you are older.

There is always the state pension to fall back on – as long as you have made the required National Insurance contributions. Then pensions minister Sir Steve Webb made headlines in 2014 when he said retirees could buy Lamborghinis with their pots if they wished.

Despite this, annual drawdowns should be carefully monitored and savers should be aware that by leaving some of their pots invested they will be exposed to market conditions.

Citizens Advice recommended that those considering pension drawdowns, rather than purchasing an annuity, should have income from other savings and assets. 

Retirees looking to drawdown should keep in mind that if they take their 25pc lump sum upfront, future withdrawals will be taxed at their marginal income tax rate.