Quick answer
Your main options
Since the pension freedoms legislation of 2015, defined contribution pension savers have had much greater flexibility in how they access their pension. The main options are:
- Take up to 25% as a tax-free lump sum
- Buy an annuity, a guaranteed income for life
- Enter drawdown, keep your money invested and draw an income as needed
- Take your whole pot as cash (usually not recommended)
- A combination of the above
You do not have to make all these decisions at once. You can phase your retirement, taking some of your pension at one time and the rest later. This can be a tax-efficient way to manage your income in retirement.
Taking a tax-free lump sum
You can take up to 25% of your pension pot as a tax-free lump sum, subject to the lump sum allowance of £268,275. This is one of the most valuable benefits of a pension, money that comes out completely free of income tax.
You do not have to take the full 25% at once. You can take it in stages, for example, taking 25% of each withdrawal as tax-free cash under an uncrystallised funds pension lump sum (UFPLS) arrangement.
The remaining 75% of your pot is subject to income tax when you take it. How much tax you pay depends on how much you take and your other income in that tax year.
Buying an annuity
An annuity converts your pension pot into a guaranteed income for life (or a fixed period). You pay a lump sum to an insurance company and they pay you a regular income, monthly, quarterly or annually. The income is guaranteed regardless of how long you live or how investment markets perform.
Annuity rates depend on your age, health, the options you choose (such as inflation protection or a spouse's pension) and prevailing interest rates. If you have health conditions or lifestyle factors that reduce life expectancy, you may qualify for an enhanced annuity that pays a higher income.
Annuities fell out of favour after pension freedoms, but they remain a valuable option for those who want certainty of income and do not want to manage investment risk in retirement. Shopping around for the best annuity rate is essential, you are not obliged to buy from your existing pension provider.
Steve's observation
The annuity versus drawdown decision is one of the most important financial decisions most people will ever make, and it is irreversible once you buy an annuity. I see people dismiss annuities without really understanding what they are giving up.
An annuity provides something that is genuinely very difficult to replicate: a guaranteed income for life, no matter how long you live. For someone who lives to 95, an annuity taken at 65 might pay out for 30 years, far more than the pot was worth when they bought it.
The right answer is different for everyone. Some people are better suited to drawdown; others to an annuity; many to a combination. This is an area where taking advice can make a very significant difference to your retirement income.
Entering drawdown
Drawdown (or flexi-access drawdown) allows you to keep your pension pot invested and draw an income as and when you need it. You have complete flexibility over how much you take and when, you can take a regular income, irregular withdrawals or nothing at all in a given year.
The advantage of drawdown is flexibility and the potential for continued investment growth. The disadvantage is that the income is not guaranteed, if your investments perform poorly or you draw too much, your pot could run out. Managing drawdown effectively requires ongoing attention and, ideally, financial advice.
Guide 18 covers pension drawdown in detail.
Combining options
Many people find that a combination of options works best. A common approach is to use part of the pension pot to buy an annuity, providing a guaranteed income floor, and keep the rest in drawdown for flexibility and growth potential.
Another approach is to phase retirement, taking some pension income at one age and the rest later. This can be tax-efficient and allows you to manage your income in retirement more flexibly.
Defined benefit retirement
If you have a defined benefit pension, your retirement options are different. You will receive a guaranteed income from the scheme's normal retirement age, based on your salary and years of service. You may also have the option to take a tax-free lump sum in exchange for a reduced annual income (called commutation).
Defined benefit pensions do not offer the same flexibility as defined contribution pensions, but they provide certainty of income that is very valuable in retirement.
Pause for thought
- Have you thought about how you want to access your pension when you retire, annuity, drawdown or a combination?
- Do you know how much guaranteed income you will have in retirement from all sources (state pension, defined benefit pensions, annuities)?
- Have you considered whether your health or lifestyle might qualify you for an enhanced annuity?
- Are you aware of the tax implications of different ways of accessing your pension?
Coaching point
Key terms
Frequently asked questions
What to do next
Think about which retirement option or combination of options might suit your circumstances. Guide 17 explains taking a lump sum from your pension in more detail, and Guide 18 covers drawdown.