Your pension options explained

Find out what you can do with your pension pot

Sarah Pennells – Virgin Money Living Mentor

by Sarah Pennells | Independent Money Mentor

Founder of SavvyWoman and award-winning journalist.

Talking about pensions may fill you with the same conversational dread as bantering about your hairdresser’s love life or discussing the various different ways to avoid the Barnstaple bypass. But it’s important stuff and there are decisions to be made that can have a major impact on your life. While we’ll probably struggle to make them exciting, we hope to at least make them understandable…

These days, retiring comes with many more pension options. You may choose to work part time, reduce your hours gradually or do something completely different, such as turn your hobby into a business (finally a chance to make that fortune from creating bespoke kilts for cats…)

You may also have more choice about what you do with your pension, but it will depend on the type of pension you have. If you have a pension where you (and your employer, if it’s a workplace one) pay in, and the amount you get at retirement isn’t a specified amount, then, since a rule change in April 2015, you can take your pension in a way that suits you when you retire.

What type of pension do you have?

You may have more than one type of pension, especially if you’ve had several jobs. The type of pension that gives you choice when you retire is often referred to as a ‘defined contribution’ or ‘money purchase’ pension.

If you have taken out a personal pension – maybe directly with a pension provider or through a financial adviser – it will be one of these pensions. But if you have a pension through your workplace it could be a defined contribution pension or one promising specified benefits at retirement (often called ‘defined benefit’ pension). With defined benefit pensions you don’t get the same choice when you retire so it is worth making sure you understand which type of pension you have.

Pension choice: the basics

You have to be aged at least 55 in order to take money out of your pension but, as long as you are, and it’s not a defined benefit pension you can decide what’s best for you.

There are five main options when you retire:

1. Leave your pension where it is. If you don’t need your pension you don’t have to do anything with it. There’s no rule that says you have to cash in your pension just because you’ve retired.

2. Cash in your pension in one go. The first 25 percent of your pension fund is tax free, but you’ll pay tax on the rest – which could be a lot of tax!

3. Take money out of your pension in smaller amounts. Here, the first 25 percent of each lump sum you take out is tax free. 

4. Take an income from your pension using something called ‘income drawdown’. 

5. Convert some or all of your pension into a guaranteed income for life by buying an annuity. 

You may want to mix and match your options – it doesn’t have to be one or the other. Let’s look at the options in more detail…

Option one: leaving your pension where it is

You can leave your pension where it is until you need it and while your pension is untouched, there’s no tax to pay. If you choose this option, it’s worth checking where your pension money is invested, if you don’t already know.

If most of the fund is invested in company shares, you may find the value of it yo-yos (possibly alarmingly!) if the stock market has some ups and downs. As a general rule, the older you are, the less risk you should take with your investments.

You should be able to switch your pension into lower risk funds. If you’re not sure what to do, it’s worth talking to your pension provider or paying for advice from an independent financial adviser.

It’s also worth checking the charges. Find out how much your pension provider is charging you to look after your pension. If charges are high, this could eat into any returns.

The real benefit of leaving your pension where it is, if you don’t need the money, is that it should be able to grow – tax free. The return on your pension isn’t guaranteed, but hopefully if you leave it untouched it will be worth more over the years.

You can leave your pension to your loved ones and, if you die before you take any money out of it, there may be no tax for them to pay at all. The rules say that if you’re under 75 when you die and there’s money in your pension pot, those who inherit it won’t have to pay income tax on it. The only exception is if they wait for more than two years after the pension provider is told of the pension owner’s death to take money out of it.

If you’re aged 75 or over when you die and you pass on your pension, those who inherit would have to pay income tax at their marginal rate. This effectively means tax at their personal highest rate. So, if, for example, you’re normally a basic rate taxpayer, but getting a payment from an inherited pension puts you into the higher (40 percent) tax rate, you’d have to pay income tax on the money you received at 40 percent.

If the person who’s died had taken their tax-free cash lump sum but not yet spent it, that money would become part of their estate as normal and there may be inheritance tax to pay, depending on how much the estate is worth.

Option two: Cashing in your pension

This might seem like a great way of taking control of your pension, but there are some major downsides. For a start, only the first 25 percent of your pension is tax free and you’ll be taxed on the rest.

So, if you have a £80,000 pension fund and cash it all in, the first £20,000 will be tax free but you’ll pay income tax on the other £60,000. In the current tax year, that would mean you would pay income tax at 40 percent on part of the money you take out.

If you decide to cash in your pension, you’ll also have to decide what to do with the money. If you put it in a savings account, the interest rate may be lower than inflation, which means your cash will be losing value.

Option three: Taking cash out of your pension in smaller amounts

You may be able to take money out of your pension in smaller amounts. If you do this, the first 25 percent of each withdrawal is tax free, but the rest is taxable.

The advantage is that you should pay less tax than if you take it all out in one go because you can spread out the withdrawals over two or more tax years. It’s not as flexible as option four below, but it can be a way of taking out quite small lump sums as and when you need them (as long as your pension provider lets you).

Because the rest of your pension money will remain invested (as with option one), you should make sure that you are not taking on too much risk.

Some pensions are more flexible than others, so your pension provider may not let you take out smaller amounts. In that case, you might have to transfer it to another company.

Option four: Taking an income using income drawdown

Another option is to take a regular income from your pension. This might sound identical to option three, but it is quite different. With income drawdown, sometimes called ‘flexi-access drawdown’, you can take 25 percent of the whole fund tax free upfront. The rest of your fund would then be moved into a pension that offers income drawdown or left where it is, if that pension lets you do income drawdown.

Income drawdown pensions have the advantage of letting you take income monthly, every few months, once a year or as a one-off and to vary the amounts you take – so they’re very flexible. Your money is normally invested in a way that’s designed to produce an income, and, if you can afford to do this, you can choose to take out only whatever your fund generates in income and leave the rest to grow. But you’d need a fairly big pension fund to do this!

One big advantage of income drawdown is that you can get 25 percent of your pension tax free upfront without having to cash in the whole fund. But income drawdown does have some disadvantages. For a start, the charges can vary widely between different providers and may include a set-up charge, an annual charge and/or a charge when you take money out. It’s also worth knowing that if you don’t take any tax-free cash at the outset (namely, before you set up the income drawdown plan), you can’t take it out later on.

As with the option of taking lump sums out of your pension, there is a risk that you may outlast your pension. In that case, you would have to rely on any other pensions you have, or the state pension.

Not all pensions let you use income drawdown, so check with your pension provider. If it doesn’t, you may have to transfer your pension to one that does.

Option five: Buying an annuity

Converting some or all of your pension fund into an annuity has one big advantage: you will get an income for the rest of your life, no matter how long you live.

Buying an annuity means you hand over your pension fund to an annuity provider and in return it pays you a fixed income every month for life. The amount you’ll get every month depends on factors such as how old you are when you buy the annuity and your health (as this may affect how long you will live for).

There are different types of annuities; for example, you can buy one that will pay you an income that rises with the cost of living and/or an income to your husband or wife after you die.

But, just as savings rates are low at the moment, so are annuity rates. And that means your pension fund will produce a far lower income each year than it would have done a few years ago.

If you buy an annuity, make sure you shop around first. Many people buy their annuity from the pension provider they’ve saved with, but you don’t have to do this and you could get a higher income for life by going elsewhere.

Where to find out more

Your own pension provider can give you information, but they’re not allowed to give you financial advice. But you can get some free help from a government-funded organisation called Pension Wise. You can book a telephone appointment, a face-to-face meeting or go online. Find out more at or ring 0800 138 3944.

So those are your options when it comes to pensions. We wish you all the best planning for the perfect retirement - and with the launch of Kilty Kitty (trademark pending).

Before making financial decisions always do research, or talk to a financial adviser. Views are those of our mentors and customers and do not constitute financial advice.