Drawdown is a way to take an income from the money that was invested in your defined contribution (DC) pension scheme. Unlike with an annuity (where your pension savings purchase a product that pays you a fixed income for life), the money remains invested in a drawdown scheme, and you choose how much to withdraw each year.
Drawdown and pension freedom
Previously, restrictions on drawdown meant that for many pension savers it was not a practical choice. With the lifting of these restrictions from April 2015, everyone with a DC pension could potentially use drawdown, and so be able to withdraw as much of their fund as they wish at any one time. However, there are many factors to consider (such as tax, investment growth and how long the fund needs to last) which mean that this option may not be suitable for everybody.
The first big advantage is flexibility. You retain control over your pension pot, effectively using it as a kind of bank account that you can draw upon as necessary. This means you can make bigger withdrawals in years where you need to spend more, and take lower sums at other times. Furthermore, 25 per cent of each withdrawal you make will be tax free. The other big advantage is that you will be able to pass on any unused funds tax-free to your beneficiaries (unlike with an annuity, where the benefits usually end upon your death).
What happens if I die?
Any unspent money in your pension pot can be passed on to your beneficiaries free of inheritance tax. This makes your pension a potentially very useful tool for inheritance tax planning.
The biggest risk of drawdown is running out of money. Unlike an annuity, which guarantees you an income for life, a drawdown fund can be depleted. If there is high growth you may be able to live off just the interest for a while (so as to leave the original sum untouched), but it is likely that over time the invested sum will diminish. The smaller the sum, the less money will accumulate in interest, so your savings will reduce at a faster and faster rate unless you also sufficiently reduce your withdrawals. Also, because the fund remains invested, it will still be at risk of fluctuations and could go down instead of growing. Remember too that large withdrawals will be subject to income tax, up to the highest rate – only 25 per cent of each withdrawal is tax-free.