Pension flexibility has increased the options available for those who wish to phase retirement. Discover the main types of withdrawal method and how it works in practice.
Phased retirement may be used to allow a pension holder to gradually cut back on their working hours and replace the associated loss in income by partially crystallising their pension fund.
The goal of phasing in the new world is to provide the optimal withdrawal method to match a client’s income requirement, in a tax efficient manner.
Types of withdrawals to support a phased retirement are the Uncrystallised Funds Pension Lump Sum, drawdown income and the Pension Commencement Lump Sum.
What is phased retirement?
Phased retirement is where unvested pensions funds are used in tranches to provide an income. It is not normally available through occupational schemes; however, most personal pension schemes are set up with multiple arrangements so the payment of benefits can be staggered.
How it works
Phased retirement is used to allow a pension holder to gradually cut back on their working hours and replace the associated loss in income by partially crystallising their pension fund. Historically, the preferred method used the Pension Commencement Lump Sum (PCLS) to fund the majority of the required income, this also minimised the amount of funds which needed to be crystallised which had additional advantages in terms of the taxation of death benefits. However, the Taxation of Pensions Act 2014 moved the pivotal point for death benefits from the previous uncrystallised funds versus crystallised funds, to pre and post age 75. As such, the additional tax on death, previously associated with phased retirement no longer applies.
However, this doesn’t detract from the desire of many clients to ease their way into retirement. The flexible legislation has opened new methods of achieving the client’s goal of gradual retirement. So, before we discuss phasing strategy, let’s look at the main types of withdrawal methods available.
Types of withdrawal
The table below summarises the pension withdrawal methods which can be utilised in respect of phased retirement (more details on each are available in our technical centre).
Uncrystallised Funds Pension Lump Sum (UFPLS)
An authorised lump sum that is paid directly from uncrystallised funds.
25% of the fund is paid free of income tax*
75% of the fund is taxed at marginal rates
* This may be less than 25% where the member is aged over 75 years.
From crystallised funds in either flexi-access or capped drawdown (if capped drawdown was established before April 2015)
A withdrawal paid out of crystallised funds.
Subject to marginal rate income tax
Pension Commencement Lump Sum
A tax-free lump sum paid alongside funds being crystallised (normally into Drawdown or an annuity). Limited to one third of the amount designated to purchase an annuity or drawdown, up to 25% of remaining lifetime allowance.
Paid free of income tax
The goal of phasing is to provide the optimal withdrawal method to match a client’s income requirement, in a tax efficient manner.
This can be achieved by using taxable withdrawals where there is remaining personal allowance (and perhaps the basic rate tax threshold in the case of higher value withdrawals) and tax-free withdrawals such as PCLS to provide any excess that would otherwise be taxable. Over time this could result in funds being built up within the drawdown environment. These funds usually remain tax free on death prior to age 75.
Various combinations of withdrawal methods can be used to achieve the required goal of phased retirement. It is therefore important to consider which strategy suits the individual client, which may be influenced by additional issues such as, the client’s tolerance to strategy complexity and individual advisor charging agreements, to name just a few.
The strategy may have to evolve and change over time, as the availability of withdrawal options change within the client’s pension arrangements, for example, no more Pension Commencement Lump Sums being available.
Let’s look at two different methods of achieving phased retirement:
In Strategy A the year on year stepped approach is:
use withdrawals from crystallised drawdown funds, to use up any remaining Personal Allowance; then
use PCLS to reach desired income level if possible (with the associated amount being vested to drawdown).
if no PCLS available (as uncrystallised funds have been exhausted) use (1) above, to provide taxable income up to the target income.
use UFPLS to provide the required level of income.
We will use the following case study to test the effectiveness of the above strategies.
Michael is aged 61 and is looking to reduce his working hours, until he finally retires at age 66 (when he receives his state pension). He currently earns, and wishes to continue to receive a net income of £16,000 per annum, although he can accept some risk of this fluctuating. He anticipates that his reduced income from employment will be £9,100, increasing by 2.5% per annum. He has £100,000 in a personal pension and would like information on meeting his income need tax efficiently. For the purposes of the example we have ignored any growth on the value of the funds.
The below case studies assume an increase to the personal allowance, for tax years 2021/22 to 2025/26 this has been frozen. The below is to show the potential complexities in funding should the personal allowance increase.
Additionally, Michael is not affected by the Scottish Rate of Income Tax (SRIT) or the Welsh Rate of Income Tax (CRIT), this would alter the figures for taxation, more information on SRIT can be found in the 'SRIT Facts' article. For more info on CRIT and how this works in practice, please visit our facts page.
Strategy A - PCLS
In Strategy A the year on year stepped approach is to use withdrawals from crystallised drawdown funds, to use up any remaining Personal Allowance (PA); then use PCLS to reach desired income level if possible (with the associated amount being vested to drawdown).
Total Net Income
Designated To D/Down
Remaining In D/Down At YE
Assumes 2.5% increase in personal allowance (i.e. not using announced intended future allowance if available)..
Over this period a total of £57,712 of Michael’s fund has been crystallised, £23,544 of which remains in drawdown. This has generated Nil in tax for HMRC. £44,289 of the pension fund remains uncrystallised..
Strategy B - UFPLS
This method uses UFPLS to provide the full shortfall in income for a given year. As with the previous strategies the first five years of this method are shown below:
Tax on UFPLS
Total Net Income
Assumes 2.5% increase in existing income and personal allowance. Tax at 20% has been deducted from the taxable UFPLS portion (i.e. the taxable element in excess of personal allowance).
Over this period a total of £33,552 will be withdrawn by Michael as UFPLS, generating £1,385 in tax for HMRC. The balance of the pension funds £66,447 are still within the uncrystallised pension fund. Although, we have ignored it for the purposes of the example, it is important to note that emergency tax is likely to be applied to each UFPLS (assuming that these are taken annually as one off payments) and as such the tax outlay using UFPLS may initially be higher than that expected, although any excess tax can be reclaimed it would create an initial income shortfall.
Remaining Uncrystallised funds
Remaining Crystallised funds
Total funds remaining
In this example, as you might expect, strategy B is the least tax efficient but retains the highest level of uncrystallised funds. Although the level of crystallisation no longer has any impact on the level of death benefits, it does maintain a higher level of access to future PCLS and UFPLS and as such maintains a higher level of future flexibility.
Of course, whilst the personal allowance is frozen the figures in the first row of each table will be the figures to use, until any planning goes beyond 2025/26 when a suitable inflation assumption would need to be used.
It is clear from the simple example used above, there are a number of ways benefits could be phased. The role of the at-retirement adviser in future will include helping their client to choose the most appropriate mix to fulfil their needs. Guidance Guarantee makes clients aware of their options, but professional advice has never been so important.