Preparing for retirement: what to do with your pension

You’ve had a long working career and retirement is fast approaching. This is a time many people look forward to, but understanding what to do with your pension pot can feel like a minefield. 

While pensions can be complicated, they need not be. Taking a few key issues into consideration can provide you with the peace of mind that you can live comfortably in retirement. 

Keeping track of all your pensions

Over a working career it is not uncommon for people to work for several employers and have several pension plans. In order to keep things simple, some people contact previous employers and have their pension fund transferred into a personal pension plan or self-invested personal pension (Sipp) so that all their pension savings are in one place. 

Having all your pension savings in one plan can make a lot of sense. It not only makes it easier for you to keep track of your money, but it can also reduce the costs charged by plan providers.

One important point to bear in mind when consolidating your pensions into one pot is to take into account whether they are defined contribution (or money purchase) plans or defined benefit (or final salary) plans.

Nowadays, most private sector plans are money purchase plans. Here, the money invested in the pension is used to provide an income in retirement. The amount you receive is based on how much money has been built up over the years and the investment returns received from them. The value of such plans can rise and fall and can have a big impact on what kind of retirement lifestyle you can afford.

If you have a final salary pension plan from a previous employer, you need to think very carefully before transferring these into a Sipp. Final salary pension plans provide a guaranteed income for life which is often adjusted for inflation. 

These benefits are rare these days and can be very valuable if the amounts involved are significant. Seeking financial advice before considering transferring a final salary scheme is a good idea. If your defined benefit plan provides you with an income of £30,000 a year or more, you will be required to do so before you make a transfer. 

Once you are happy with the location of your pension plans, it is time to start thinking about how you might access your pension pot when you retire.

The tax-free lump sum

Under current pension rules, an individual can take up to 25 per cent of their pension pot as a tax-free lump sum when they retire. At the moment, this can be done when they reach 55 years of age, but that age limit will increase to 57 from 6 April 2028.

The maximum amount you can withdraw is currently capped at £268,275 – 25 per cent of the previous (now abolished) pension lifetime allowance of £1,073,100.

Lump sums are a major attraction of pension savings and can form a major part of people’s long-term financial planning. They are often used to pay off mortgages, make big purchases such as home improvements or to help children get a foot on the housing ladder.

However, just because you have the option to take a tax-free lump sum, it doesn’t mean you have to take it immediately when you retire. It may make sense to leave the money invested in your pension fund with the capability of further tax-free growth. Instead, you could use money from other sources of savings, such as Isas, to fund your lifestyle.

You can also take your lump sum gradually over time to manage your income tax bills in retirement.

Should you buy an annuity?

An annuity is a guaranteed income for life. The amount of income you will receive is closely related to the interest rates available on the government bonds which insurance companies use to fund them. 

When interest rates were very low, in the not-so-distant past, annuities looked like a very poor option. However, now that interest rates have increased from near zero to 4-5 per cent on UK government bonds, the income that annuities provide look a lot more attractive than they have done for some time.

Annuity income available from a £100,000 pension pot 

Age	Fixed	RPI Increase	5% per year
55	£6,615	£3,970	£3,303
60	£6,982	£4,428	£3,742
65	£7,718	£5,207	£4,558
Source: Moneyhelper.org.uk as of July 2025

To simplify this, a 55-year-old man retiring now with no health issues (health conditions can actually boost annuity income because the insurance company does not expect to pay it for as long) could get a fixed return of just over 6.6 per cent for the rest of their life. A 75-year-old could get 7.7 per cent.

Put another way, the 55-year-old would only have to live to just over 70 to get their money back while the 65-year-old would have to live to 78 to achieve the same result.

Annuities have their drawbacks, but they have their advantages, too. They take away investment risk and provide peace of mind that you will never run out of money. They can also come with guarantees which can pay money to your estate if you die or a percentage of your income to your spouse.

Another advantage of annuities is that they provide flexibility. You do not have to put all your money in an annuity. Instead, you could use them to cover your household expenses and then use other methods such as drawdown for any extra money that you need.

The biggest drawback of a fixed annuity income for life is that it does not protect you from the impact of rising prices (inflation) which means that the income will buy fewer goods and services over time.

To get around this, you can purchase annuities that increase your income every year in line with the retail prices index (RPI) or by a fixed amount such as 5 per cent. This may provide peace of mind but to get that, the starting levels of income are typically much lower. It can take many years for the cumulative amount of income paid out to surpass that paid from a fixed annuity.

Tax-efficient pension drawdown

Handing over large sums of money to an annuity provider means you cannot get it back. It also removes the ability of your pension fund to keep on growing tax free in retirement. 

If you can cope with the uncertainty of variable investment returns, then leaving your fund invested and drawing down an income from it might be a better option for you. It can also come with tax advantages as well.

Apart from the tax-free lump sum, if you take an annuity and have a large pension pot you could end up paying a lot of income tax once your pension income has exceeded your annual personal allowance of £12,570.

By having the ability to take money as and when you need it, drawdown gives you the ability to manage your income tax liability better than with an annuity.

There are two main types of drawdown that you might want to consider. One version is known as flexible access drawdown (FAD), and another is uncrystallised funds pension lump sum (UFPLS).

Flexible access drawdown

In this case, you typically take the 25 per cent tax-free lump sum upfront in full, with the remaining 75 per cent of the fund remaining invested in a drawdown fund which can then be drawn from for income. You can choose to take as little or as much income as your pension fund will allow, and will pay income tax at your marginal rate.

FAD means that you crystallise your pension fund and take a tax-free lump sum. Crystallisation is just another way of saying that the funds have been accessed.

The fund remains invested, which means it can grow but also fall in value.

Uncrystallised funds pension lump sum

In this case, you don’t take a regular income via drawdown. Instead, you take lump sums from your pension pot, with the first 25 per cent being treated as a tax-free lump sum and the remaining 75 per cent taxed as income.

The big difference between the two concerns how much tax you might pay.

With UFPLS, you take your money from uncrystallised funds. Once these have been exhausted you cannot have 25 per cent free lump sums anymore. The best way to show the difference between FAD and UFPLS is with an example.

FAD vs UFPLS with a £400,000 pension

	FAD	UFPLS
Starting pot	£400,000	£400,000
Lump sum 25%	£100,000	0
Crystallised benefits	£300,000	0
Uncrystallised funds	£0	£400,000
Year 1:
Income taken	£25,000	£25,000
Crystallised benefits	£275,000	0
Uncrystallised funds	£0	£375,000
Taxable portion	£25,000	£18,750
Tax free	0	£6,250
Personal allowance	£12,570	£12,570
Tax paid at 20%	£2,486	£1,236
After-tax income	£22,514	£23,764
Source: Investors’ Chronicle

Here we have a starting pension pot of £400,000. Under FAD, 25 per cent is taken as a tax-free lump sum, leaving £300,000 in crystallised benefits in a pension drawdown account. In the first year of retirement, £25,000 is drawn down leaving £275,000 in crystallised benefits (to keep things simple, no investment growth in the pension is assumed here). 

Assuming tax is being paid at 20 per cent, the individual is left with an after-tax annual income of £22,514.

Under UFPLS, no tax-free lump sum is taken immediately, leaving £400,000 in uncrystallised funds. Taking the same £25,000 as under FAD means that 25 per cent of it is treated as a tax-free lump sum with the rest as income. The individual can keep on doing this until their crystallised funds are exhausted and the cumulative £100,000 tax-free lump sum allowance has been used up.

The advantage under UFPLS is that the after-tax income is higher than under FAD. Where the pension pot is large and drawdown amounts would exceed the 40 per cent tax threshold of £50,000, UFPLS can be very effective at keeping the tax rate at 20 per cent.