When it comes to planning your retirement, navigating pension options can be overwhelming. Choosing the right pension option for you can be stressful; after all, your future and that of your family are at stake. As with all finance matters, there is no ‘one size fits all’ approach.
The best pension depends on your circumstances, goals and risk tolerance. An annuity provides guaranteed income for life but lacks flexibility. Drawdown offers more income control and potential growth but carries risk. Combining both is viable, but it’s vital to balance short and long-term needs.
Fortunately, the experts at Heritage Financial Planning are here to help. In this article, we will explore the different ways you can access your pension and the associated pros and cons.
For more personalised pension advice, please contact us to arrange a consultation.
When can I access my pension pot?
At the time of writing, individuals with a defined contribution pension* can typically start withdrawing an income or lump sums from their pension pot from age 55. This is set to increase from April 2028 to age 57.
However, certain private pensions will have a protected pension age of 55 even after 2028, so it’s important to check with your pension provider, particularly if you fall into the 55-57 age bracket and/or are looking to transfer your pension.
*a retirement plan with pension contributions from both the employee and employer, which are invested with the risk borne by the retiree.
What counts as tax-free cash?
You can usually take 25% of your pension pot tax-free. This is known as a ‘Pension Commencement Lump Sum’.
With some more mature pensions, it may be possible to take more than this if you have protected tax-free cash, so it’s always worth checking if any such benefits are available.
It is important to note that you do not have to take all of your tax-free cash at once. Depending on your pension provider or pension scheme and whether they offer drawdown, you may be able to take your tax-free lump sum as a series of smaller lump sums or even as an income.
Although it can be tempting to take all of your tax-free cash, you should bear in mind that the more capital you take initially will result in a smaller pension pot in the future. Striking a balance between immediate cash needs and ensuring sufficient funds for the long term is essential to securing a financially stable retirement.
Flexi Access Drawdown scheme versus Lifetime Annuity
Let’s examine the different pension pot options, including the valuable benefits they offer as well as the risks.
Flexi Access Drawdown
Drawdown allows you to take your pension benefits flexibly, and you can take as much or as little income as you like. If you begin to take benefits from your pension flexibly, you can increase, decrease or even stop your withdrawals entirely.
Rather than converting your entire pension pot into an annuity (i.e. regular defined payments), drawdown allows you to take an income while leaving the rest of your money invested. This means your pension remains in the market, potentially benefiting from investment growth.
An example of how drawdown works can be seen in the following scenario:
- John is age 65 and retired.
- He has £200k in a pension pot
- We will assume his investments grow at 4% net of all fees
- He withdraws £8,000 per year, which rises with inflation
In this example, John’s pension would run out at age 94. In fact, by age 85, he would have over £113,000 in his pension.
What happens to my drawdown pension if I die?
Under current legislation, if you die before age 75, then your beneficiaries can receive your pension tax-free. This can be taken as a lump sum or even as a regular income.
This is known as ‘beneficiary drawdown’. If you die after age 75, then any withdrawals will be taxable at their marginal rate of income tax.
Along with the flexibility it offers, these death benefits are what make drawdown a popular retirement strategy.
What’s more, under current legislation, pensions do not form part of your estate for inheritance tax purposes. Therefore, drawdown can be an effective strategy for mitigating inheritance tax if you are over the threshold.
What are the advantages of Flexi Access Drawdown?
- Flexibility. A drawdown’s flexibility is one of the reasons why it is so popular. The ability to shape your income around your personal circumstances is particularly useful when you factor in other assets such as the state pension and Defined Benefit pensions.
- Death benefits. As we have seen, a drawdown can have favourable death benefits compared to an annuity. This means you can pass your remaining pension to your loved ones.
- Control. You have the ability to control both the withdrawals that you take but also the investments within your pension.
- Benefit from potential investment growth. You have the ability to benefit from future investment growth, which can support your pension in future years. But, of course, your pension pot is at risk if your investment performance is worse than expected.
- Tax efficiency. You can use both your tax-free cash and taxable withdrawals up to your personal allowance to minimise your tax liability.
What are the disadvantages of Flexi Access Drawdown?
- Income is not guaranteed. The biggest disadvantage is that if your investment performance is worse than expected or you take an unsustainable amount of income, you could run out of money.
- It requires maintenance. As your remaining pension pot is left invested, it should not just be left on auto-pilot. Your investments will require careful monitoring, as will the sustainability of your withdrawals.
- Charges. You will be required to pay platform and/or fund charges. If you hire a professional to help manage your investments, this can add a further layer of fees.
- Annuity rate fluctuation. If you plan on buying an annuity in later life, annuity rates may be lower, meaning you will receive less income.
An example of when drawdown can go wrong
In this example, we will use John’s example from earlier, but we will assume his remaining pension grows at 3% a year, and he withdraws a higher initial amount of £12,000 per year.
The combination of higher withdrawals and lower investment performance in this example would mean John would run out of money at age 82 (rather than at 94 in the previous scenario).
An annuity is a financial pension product that transforms a lump sum of money, typically your pension pot, into a regular income stream. It provides you with a guaranteed income for life, or for a fixed period, depending on the type of annuity you choose.
You can take your 25% tax-free lump sum before you purchase an annuity or look to purchase an annuity with the whole lump sum.
The level of annuity you receive depends on variables such as:
- Your age
- Underlying interest rates/Annuity Interest Rates
- Your health
- If you are a smoker
- Your retirement savings
- Where you live
Annuity sales fell dramatically as a simultaneous result of the introduction of the Flexi Access Drawdown scheme in 2015 and ultra-low interest rates following the banking crisis of 2008, the effects of which lasted until 2020.
However, as interest rates and gilt yields have risen in recent years, annuity rates have increased and have become more attractive, as you can see in the chart below:
The chart shows an example of what you could achieve from purchasing an annuity with a £100,000 pension pot at the age of 65 on a single-life basis (i.e. where there are no other beneficiaries).
It shows that it is possible to achieve an income of £7,352, which means the annuity rate is 7.35%. This is an example, and the amount you may be able to achieve could be higher or lower than this.
If, for example, you were to add 50% spousal benefit (meaning it would pay 50% of the annuity to your spouse on your death until they die), this would lower the amount of annuity you can achieve.
Advantages of an Annuity
- Less risk. An annuity provides a predictable income for life, which is comforting if you are risk-averse. Although, remember that your annuity is subject to inflation.
- ‘Hands-off’. You don’t have to worry about investment performance or withdrawal rates as with drawdown.
- Option to add protection for your loved ones. You can add capital protection and a spousal pension if you die (although you may get a lower initial rate).
Disadvantages of an Annuity
- Lack of flexibility. With an annuity, usually, you cannot change the amount of income from one year to the next.
- No death benefits. Assuming there is no spousal pension or capital protection, the annuity income will die with you. Unlike pension drawdown, there is no pension pot for your loved ones to benefit from. If you die prematurely, there is a possibility your annuity payments could be less than the pension pot you used to purchase the annuity.
- Locked in. Once you have purchased an annuity, it is not usually possible to change your mind.
Like any financial decision, purchasing an annuity requires thoughtful consideration and professional guidance. Typically you have to trade some or all of your pension pot to achieve an annuity which reduces your flexibility and options in the future.
It’s important to speak to a financial adviser to help you balance your goals for a steady income with your future financial needs.
Uncrystallised Funds Pension Lump Sum (UFPLS)
UFPLS allows you to take lump-sum withdrawals from your pension pot without converting your entire pension pot into an annuity or entering a regular drawdown plan. Instead, you can choose to take one or multiple lump-sum withdrawals, leaving the rest of your pension pot untouched and potentially invested for future growth.
Each lump sum withdrawal from your uncrystallised pension funds will be treated as follows – 25% of the UFPLS amount can be received tax-free, while the remaining 75% will be subject to taxation as pension income at the time of withdrawal.
It is also possible to take your whole pension as a lump sum; however, this would only be suitable in a very small amount of cases as the tax liability could be significant, and you will have no retirement income in the future.
Taking a series of smaller UFPLS as a monthly income can be a very tax-efficient way of withdrawing money from your pension.
This is because 25% will be tax-free, and although the remaining 75% will be classed as taxable income, if you have no earnings, the first £12,570 is taxed at 0%. This can be very useful for retirees who have no income but have not yet reached state pension age.
Which is the best option for me?
There is no right or wrong answer when it comes to taking money from your pensions, and it very much depends on your individual circumstances. If you are unsure of your pension choices, then you should seek professional advice.
When considering the flexibility of pension drawdown vs a guaranteed income via an annuity, you should consider the following factors:
- Your other assets and pensions. If you are fortunate enough to have other forms of guaranteed income alongside the state pension, such as Defined Benefit pensions, you could argue that a secured guaranteed income is less important and you can afford to take stock market risk. This may also be true if you have other assets, such as rental properties.
- Your risk tolerance and investment experience. If you’re not an experienced investor, a drawdown may not be appropriate without professional guidance, as your investments will require regular monitoring. During stock market volatility, with no experience, you could be moved to sell your investments, causing significant damage to your pension plan.
- Do you want flexibility when taking money from your pension? If you want to have the ability to vary your retirement income, then a drawdown pension option (or one combined with an annuity) will enable flexibility.
- Do you wish to leave a legacy and ensure your loved ones can benefit from your pension? With an income drawdown, your beneficiaries can benefit from your remaining pension pot if you die. With an annuity, this typically dies with the owner (unless any guarantees are built-in).
Combining the best of both worlds
It is not a binary decision when it comes to your pension options; it’s possible to combine the flexibility of drawdown and the security of a guaranteed income by using some of your pension savings to buy an annuity.
By blending the two, you can ensure your core or essential retirement income is met by the safety of an annuity, whilst you can use the freedom of income drawdown to fund the luxury or one-off items, such as holidays during the years and before you reach state pension age.
Will my pension scheme allow Flexi Access Drawdown?
You should be aware that not all personal pensions and stakeholder pensions facilitate flexi access drawdown as it is a complex product, and many pensions were not set up for this when drawdown was introduced in 2015. If you are considering this option, you should consult your pension provider.
When it comes to retirement planning, there is no such thing as a ‘one size fits all’ pension scheme. It is entirely dependent on your individual circumstances, goals, and risk tolerance.
Flexi Access Drawdown provides flexibility, potential investment growth, and favourable death benefits but requires careful management and carries some level of risk. On the other hand, Lifetime Annuity offers a predictable income stream for life, with less risk, but lacks flexibility and certain death benefits.
It is possible to combine the two options to get the best of both worlds, but it’s wise to consult a professional in order to strike the right balance between your immediate and long-term financial needs.
To learn more about planning your retirement and pensions, read our guide.