How does drawdown work?

True or false

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"A man aged 65 will live on average to age 83 and a woman to 85"

"A man aged 65 will live on average to age 83 and a woman to 85"

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True

Even these figures can be misleading:

• A 65-year-old female has a 1 in 4 chance of living to 94 and a 1 in 10 chance of living to 98.

• A 65-year-old man has a 1 in 4 chance of living 92 and a 1 in 10 chance of living to 96.

It’s little wonder many financial advisers routinely plan for their clients to live to 100!

When you’re ready to take an income from your defined contribution pension savings, you have to decide how to do this.

If you choose drawdown your pension pot stays invested, just like when you were saving for retirement. You can take income by simply selling part of your investments when you need money. You can withdraw what you want, when you want.

This makes drawdown very flexible, but your income isn’t guaranteed and you could run out of money. For example, if you take too much income or investment markets perform poorly.

Which is better - a guaranteed income for life or drawdown?

There are pros and cons with each option and you can combine them.

A guaranteed lifetime income provides peace of mind. You’re paid an income for life whatever happens to investment markets.

For many people this is reassuring. They can get on with enjoying their retirement, not worrying about their investments.

But there are drawbacks. These products lack the flexibility of drawdown. The income can’t be varied, nor can you take a one-off payment once the annuity has been set up.

With drawdown, you can take what you want, when you want. You have complete flexibility. Your money remains invested, and you can buy a guaranteed income for life at some later point if you want.

But your money is at risk. If you make poor investment decisions, markets perform badly, you take too much income or live longer than you expected, your money could run out.

There are other issues to take into account, but the fundamental question is whether you prefer the flexibility of drawdown or the certainty of a guaranteed income for life? Or you can combine these products. Perhaps the best of both worlds?

How do I decide where to invest my drawdown fund?

This is a critical decision – it can often make sense to seek financial advice.

If you take financial advice, you’ll get all the help you need to decide what investment strategy would be suitable for you.

If you aren’t using an adviser, your drawdown provider will offer you a default investment fund based on your plans for the next 5 years. You’ll be asked which of the following best matches your situation:

• I have no plans to touch my money in the next five years

• I plan to use my money to set up a guaranteed income (annuity) within the next 5 years

• I plan to start taking my money as a long-term income within the next 5 years

• I plan to take out all my money within the next five years

It’s not compulsory to use the default investment fund offered by your provider. 

A further option is to use a default investment fund for some of your money and invest the balance in other, non-default funds, offered by the provider.

How much income should I take?

Usually, your money needs to last a lifetime, so be careful how much you take.

At age 65, research suggests you should take no more than 2-4% of your money each year if you want it to last a lifetime. Even this doesn’t guarantee that your money won’t run out.

There are circumstances when you could consider taking more than 2-4% each year. For example:

• Poor health. If you suffer from a medical condition likely to significantly shorten your life expectancy you could consider taking a higher income.

• Other assets. If you have other savings and investments to fall back on, or if you’re prepared to release equity from your home, you could take perhaps more income.

• Ignore inflation. If you choose a fixed income that doesn’t increase each year you could take a higher income. Expenses often fall during retirement so this can make sense.

• If you’re much older than 65 when you retire. Your savings don’t need to last as long, so you could take more than 2-4% each year.

Taking more than 2-4% each year is a risk. Even if you suffer from poor health you could still live longer than expected. Alternatively, ignoring inflation may reduce the spending power of your money in future. For example, in 2008 a pint of beer cost £2.30 and a fish supper £2.43!

If in doubt, think about taking professional financial advice.

What happens when I die?

In some circumstances, there’s no tax payable on your fund when you die.

If you die before age 75, the amount in your drawdown fund can be paid free of tax, up to the lump sum and death benefit allowance of £1,073,100.

If you die after age 75, the options are the same, but any payment on death will be taxed at the marginal rate of whoever receives the money. The marginal rate basically means the tax payable on the last pound of someone’s income.

Tax treatments may be subject to change in future.

"Lump Sum and Death Benefits Allowance Explained": When you die, your pension savings pass to your beneficiary. If you die before age 75, they’ll be able to withdraw those savings without paying income tax – up to a maximum amount called the “Lump Sum and Death Benefits Allowance”.

Their allowance will be £1,073,100 less any tax-free lump sums you took when you were alive and any tax-free death benefit payments made when you die - such as a value protection lump sum. (N.B. if a tax-free death benefit was paid before 6 April 2024, this won’t count towards the allowance).

Anything over the £1,073,100 allowance will be taxed at your beneficiary’s normal rate of income tax. If you have protection from the lifetime allowance, this amount may be higher. If you die after age 75 your beneficiary would pay tax on the full value protection payment they receive.

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