What is pension drawdown and how does it work?

Pension drawdown is a way for you to take an income from your pension when you decide to retire. Your pot stays invested, and you withdraw money from your pension savings when it best suits you.

As drawdown gives you the freedom to choose when and how much to withdraw, it’s also called flexible retirement income, flexi-access drawdown, or income drawdown.

But, because your retirement income is taken directly from your pension fund, you risk running out of money if you don’t plan carefully.

At Canada Life UK, we only provide drawdown to our existing customers. Your pension provider will be able to tell you if they offer drawdown. If they do, it’s still important to shop around to ensure you’re getting the right solution for your individual circumstances. 

We always recommend speaking with a financial adviser before making key decisions about your financial future.

To put your pension savings into a drawdown, you need to :

• Have a defined contribution pension scheme
• Be at least 55 years old (this will change to 57 from April 2028 and is expected to increase again to 58 by the mid-2030s)

Whole pot versus phased drawdown

You have a range of choices when it comes to moving your pension pot into drawdown.

1. You can move your entire pension into drawdown all at once, or you can phase the process, allocating portions of your pot according to your needs. This is called a phased drawdown.
2. Depending on your circumstances, you may want to keep a portion of your pension in drawdown and buy an annuity with the remaining amount. This is called a partial drawdown.
3. Alternatively, you can also buy an annuity with money you’ve already put into drawdown. But you won’t be able to convert an annuity into a drawdown arrangement – once an annuity is in place, you can’t change your mind.

When you move your pension, or portions of it, into drawdown, you’re able to take a tax-free lump sum. This is called a Pension Commencement Lump Sum (PCLS), or ‘tax-free cash’.

‘Tax-free cash’ is a benefit of saving into a UK-registered pension scheme. In total, you’re allowed to access up to 25% of your pension pot tax free, normally  up to a maximum of £268,275. This means you can take a lump sum from your pension when you move money into drawdown – and not pay tax on it.

For example, let’s assume your pot is £100,000 and you’d like to put the entire amount into drawdown:

1. Here, you can take up to £25,000 as a tax-free lump sum.
2. The remaining £75,000 would then he held in drawdown – ready for you to draw an income from, either regularly or when needed.
3. These later withdrawals are treated as income and taxed at your marginal rate.

Phased drawdown and tax-free cash

If you move money into drawdown in phases, you can take up to 25% of the total amount you’re accessing each time as tax-free cash. Staying with the above example, if you decide to initially move only half of your £100,000 pot into drawdown, you can:

1. Take a tax-free lump sum of £12,500 (25% of £50,000), and
2. Draw on the remaining £37,500 (75% of £50,000) when needed.

An important advantage of pension drawdown is that you can access your tax- free cash without having to access  taxable income at the same time.

Your pension remains invested while it’s in drawdown. This gives it the opportunity to grow, possibly protecting its buying power against rising prices. However, investments can fall in value, too. If this happens, you’ll have less to draw an income from.

• The general rule of thumb is that while you’re still saving into your pension, you might be willing to accept more risk in an attempt to earn higher returns on your investments.
• However, when you near retirement age, you may instead want to lessen your risk and protect the value of your pension. This line of thinking also holds for pensions in drawdown.

The importance of pension advice

We strongly recommend getting professional pension advice from a qualified financial adviser before making any lasting decisions. An adviser will look at your entire financial situation and work with you to tailor a solution that best meets your individual needs – including how you should invest your pension when it’s in drawdown.

Learn more about how you might benefit from pension advice.

Investment pathways

Many providers offer ‘investment pathways’ – an initiative started by the Financial Conduct Authority (FCA) in 2021. The pathways are designed to help those who move their pensions into drawdown before obtaining professional pension advice. There are four pathways, each with a different set of investments aligned with when you plan to start drawing on your pension.

Pension drawdown versus annuities

Drawdown is often seen as an alternative to an annuity. When you buy a Lifetime Annuity, you’re exchanging some, or all, of your pension savings for a regular, guaranteed income that’ll last for life. 

However, if you choose drawdown, your income is taken directly from your pension fund – which means you could run out of money if you don’t plan carefully.

You can convert funds in drawdown into an annuity at any time if your situation or preferences change. Unfortunately, you won’t be able to turn an annuity into a drawdown arrangement.

We suggest speaking with a financial adviser to find out which option will best suit your individual circumstances.

Pension drawdown versus UFPLS

An UFPLS (pronounced ‘uf-plus’) is an ‘Uncrystallised Funds Pension Lump Sum’. The name may be a bit complicated, but the basic idea is quite straightforward.

What are ‘uncrystallised funds’?

Money you’ve saved into your pension pot is in an uncrystallised state until you decide to access a pension benefit. The funds that you use for the benefit then become ‘crystallised’. So, if you decide to:

• put your pension (or part of it) into drawdown,
• use your pension (or part of it) to buy an annuity, or
• choose a mixture of both an annuity and drawdown

the portion of your pension savings you use for these then becomes crystallised. Any portion that you haven’t used for the above remains uncrystallised.

An example will help make this clear.

Let’s say you’ve saved £100,000 into your pension, and you haven’t yet accessed any funds. In this case, the entire amount is uncrystallised.

If you then decide to take a £12,500 tax-free cash lump sum and put £37,500 into drawdown (see above), the total amount of £50,000 will have been crystallised. The other £50,000 – that you haven’t done anything with – will still be uncrystallised.

How does an UFPLS work?

Essentially, with an UFPLS, you’d take a lump sum directly from your uncrystallised savings without buying an annuity or putting funds into drawdown.

You can take your entire pot in one go, or you can keep taking lump sums until your savings are depleted.

This is the important bit: 25% of each lump sum is tax-free (up to a limit of £268,275), but the other 75% is added to your income for the year and taxed at your marginal rate. For example, if you take an UFPLS of £10,000:

• £2,500 is tax-free
• £7,500 is added to any other income for the year and taxed at your marginal rate

Depending on your personal circumstances, taking an UFPLS can result in you paying significant tax on your pension, especially if you withdraw large sums.

By comparison, when you move pension savings into drawdown, you can access your tax-free cash  without having to access taxable income at the same time.

If you die before age 75

Your drawdown pension can usually be paid to your chosen beneficiary without Income Tax. Typically, they can choose to (i) take the money as a lump sum or (ii) keep it in drawdown and take money out later.

But there are two important exceptions. Firstly, there may be a tax charge if the lump sum is above your Lump Sum and Death Benefit Allowance (LSDBA) at the time of your death. Secondly, a lump sum can also become taxable if it’s paid more than 2 years after the pension provider is told about the death.

Learn more about the LSDBA 

If you die at 75 or older

Your beneficiary can still inherit your drawdown pension, but they’ll usually pay Income Tax when they take money out (whether as a lump sum or income). Normally, they can keep it invested in drawdown and only pay Income Tax when they withdraw.

Inheritance Tax (IHT)

Important changes to how pensions are treated for Inheritance Tax (IHT) will come into effect from April 2027.

Up to 5 April 2027, pensions have often been treated as outside the estate for IHT (particularly where the scheme has discretion over who receives benefits). But from 6 April 2027, most unused pension funds and death benefits will be counted as part of your estate for IHT purposes, and the person dealing with the estate (your personal representative or executor) will be responsible for reporting and paying any IHT due (if the estate is large enough to pay IHT).

Page footnotes:

1. As with any investment, the value of your pension can fall as well rise.