What are the Pros and Cons of Pension Drawdown?
What is pension drawdown?
Essentially, it means that you leave your pension pot invested and withdraw as little - or as much - as you want. You can do this throughout your retirement, giving you far greater flexibility.
Before the rule change in 2015, the only real choice for most people at retirement was to buy an annuity, which gives a fixed sum of money paid regularly, typically for a lifetime. But it isn't always the right choice, leaving some frustrated.
It’s crucially important that flexi-access drawdown allows you to take, normally up to 25% of your pension in the form of a tax free lump sum, with the balance sitting in your pension pot with the potential to grow tax free. It’s not usually a good idea to take the full 25% tax free cash all in one go, unless it’s essential, for reasons which we’ll go on to explain. Doing this could damage your retirement plans.
Pension drawdown allows you to withdraw a regular income in addition to the tax free amount from your pension but the withdrawals from the drawdown element will be subject to income tax at your highest marginal rate.
Flexi-access drawdown is only available to people with defined contribution pensions rather than final salary. However, there’s usually an option available to transfer your final salary pension into a money purchase arrangement in which drawdown is available. Also, your existing pension arrangements may not offer a drawdown option and some drawdown arrangements don’t offer the same level of flexibility as others. On the other hand, it’s possible with older pensions that the tax free amount available could be higher than 25%. At Reeves we’ll be able to advise you on this.
It’s essential to understand all the options available when it comes to planning your retirement and this is where an independent financial adviser, such as Reeves Independent, can be invaluable.
Now, let’s look at the pros and cons of flexi-access drawdown.
One of flexi-access drawdown’s greatest strengths is the flexibility it can give you in retirement planning. When you come to take your pension, you can choose to leave your savings invested to grow over time and provide you with a larger retirement provision. You can take income when it suits you, increasing or reducing the rate of withdrawal to match your lifestyle.
Before the reform of 2015, the rules meant that most of the 400,000 people retiring every year had to buy annuities, which have become poor value in the wake of the financial crisis - driving annuity rates to record lows.
Since 2015, more than a million over-55s have taken advantage of the new rules and more than £23bn has been withdrawn from the nation’s pension pots through more than five million individual payments. However, the way pension lump sums are taxed means that those who didn’t take appropriate advice will have paid a significant amount of income tax, whereas, with professional guidance, tax at rates of up to 40% - sometimes even 45% - can be avoided.
The flexibility of pension drawdown is ideally suited to the way most people spend their retirement years. Typically, you’ll need a higher income in the early years while you’re still fit and active, pursuing interests and hobbies, going on more holidays and fulfilling long-held ambitions. As you get older, your spending and therefore your income requirements will reduce.
Annuities cannot take account of these changing circumstances, paying the same level of income throughout retirement.
Thanks to pension drawdown, you can be in control and take more income when you need it.
Tax planning benefits
The main tax planning benefit of flexi access drawdown is the ability to choose when you take what and how. There’s no requirement to use all your pension in one go, or to draw it down at the earliest opportunity.
Our strategy of phased drawdown allows our clients to minimise and defer tax especially in the earlier years of retirement when income requirements will be highest. This simply means splitting your pension into parts and converting each part to drawdown at different times, as and when you need the income.
As we’ve seen, each time you convert a part of your pension to drawdown you can usually take up to 25% of that amount as a tax-free lump sum. For those who don’t need immediate income, it’s possible to just withdraw the tax-free cash for the time being and leave the rest invested to provide a taxable income later on.
You may wish to use this tax-free cash to add to other sources of income. This could be particularly useful if you reduce your working hours or perhaps take on part-time work during retirement. The tax-free cash can supplement your earnings, without increasing the tax you pay – potentially helping you stay under certain tax bands or personal allowances.
In retirement, you can use this tax-free element to supplement your flexi access drawdown income. Let’s say your annual income requirement is £20,000 net. You could take a portion of your pension, 25% of which would be tax free, and in this instance £7,500.
Assuming you receive no other taxable income in that same tax year, you could then withdraw £12,500 (the personal income tax allowance) from the drawdown element of your pension and it would be tax free. The remaining amount in drawdown could be left invested to draw a taxable income from in later tax years.
You can move more money into drawdown as many times as you like, until you have exhausted the untouched (accrual) part of your pension. It’s important to remember tax rules can change so it is essential you or your financial adviser are up to date with legislation.
Another benefit of pension drawdown is the ability to pass any remaining pension fund on your death to beneficiaries without an inheritance tax charge. With the alternative annuity scheme, the pension will normally die with you. There are different rules on death depending on the age of the deceased. Your beneficiaries would receive your pension tax free if you were to die under the age of 75. If you’re over 75 they’ll be taxed at their highest marginal rate.
Another advantage of pension drawdown is that you’re in control of the investment decisions. This makes it essential that you have an effective investment strategy to achieve your retirement goals. We advocate a different investment strategy for those in retirement to those who are building for retirement.
A key consideration is deciding how to spread your money across the different asset classes (equities, bonds, property, cash and commodities) and how much you want to hold in each.
Asset allocation can help you to achieve your financial objectives by combining a range of investments that work together, while controlling the risk you take. In times when you are worried about market conditions you may hold higher levels of cash and/or lower risk investments. When you’re more comfortable with the market outlook you may change into an investment that can capitalise on this.
In fact, a survey by Aegon UK found that 43% of retirees were concerned about the impact of current market conditions on their retirement income sustainability. However: 58% have not reduced their exposure to equities in the last 12 months and 67% don’t plan to take any action, leaving their money where it is.
Just 11% are reassessing their current investment strategies in order to reduce the risk of their portfolio. This doesn’t identify whether the individuals are receiving ongoing advice, however, we would suggest that if they are, they’re likely to be in the 11%.
At Reeves Independent we run our own investment portfolios that have defined the shape of our client’s retirement.
It’s not a guaranteed source of income and you might live too long
Unlike the annuity option, pension drawdown is by no means a guaranteed source of income.
One of the questions we hear time and again is: will I run out of money in retirement? Nobody can predict the future and everyone’s personal circumstances are different. To be blunt, nobody can predict when you and/or your spouse will die. For those who choose the potential benefits offered by pension drawdown, the risk of running out of funds can be a major concern.
The average life expectancy for a 65-year old is around 84 for men and 86 for women, and a record number of people are also living past their 100th birthday. It’s estimated there’ll be more than 100,000 centenarians by 2035. So a 65-year-old drawdown investor might need their pension to provide an income for 20 years or even longer.
Unlike with an annuity, you need to estimate how long you’re likely to live and take on the risk that you might need your drawdown income to last longer than you expect.
That said, it’s possible to reduce the risk of running out of funds.
If you do opt for pension drawdown, you need a plan that covers a range of scenarios. You need to understand the potential threats to your retirement income and how you could deal with those threats. If it appears the risks of you running out of money in retirement are increasing there are potential solutions, but taking appropriate action as soon as a problem is identified is critical, so it’s vitally important to constantly review your pension arrangements and requirements.
Whatever you decide, you should be mindful of how long you need the pension to last, and that the performance of your investments could affect how much income you are able to take.
You have greater responsibility – and mistakes can be made
We spend a lot of time explaining to clients what a useful and tax efficient tool a flexible drawdown pension is. It’s a great way to save and to enjoy the benefits of that saving during retirement.
However, it’s important always bear in mind that the government only gives such generous tax benefits to pensions in order to encourage people to save for their retirement. Those benefits aren’t there to make a pension some sort of general purpose, tax free, rainy day fund and there are severe tax penalties attached to any attempts to do so. A pension is not a bank account.
Individuals who flexibly access pension benefits from a money purchase arrangement are subject to a money purchase annual allowance (MPAA) that limits the future contributions they can make to money purchase pension arrangements.
The amount you can invest in a pension and receive full tax relief depends on your earnings for the year and is capped at £40,000. This is known as the annual allowance.
At the point where the first income payment is taken from a drawdown account the tax relief limit falls to £4,000 for contributions. This limits your ability to top up your pension fund if you do have the funds available in the future.
It’s important to note the reduced annual allowance only applies when income is taken. It is, therefore, possible to take the initial tax-free lump sum and to still be able to contribute the full £40,000 annual allowance if no income is taken from the drawdown fund.
For some individuals with large pension pots, the lifetime allowance may also be a concern. As the name suggests the lifetime allowance (currently £1.05m) is the overall limit an individual can accrue in their pensions during their lifetime without incurring an additional tax charge when they start to draw benefits. If you’re over this limit and attempt to convert your pension to flexi access drawdown you can potentially trigger a 55% tax charge.
Successive governments have a history of changing tax percentages and limits, so it’s important to keep up with the latest legislation or use an appropriate adviser.
All investments carry some degree of risk and this applies to drawdown. Stocks, bonds, equities and commodities can lose value, if market conditions are unfavourable.
During your retirement years, if a high proportion of negative returns occur in the beginning years of your retirement, it will have a lasting negative effect and reduce the amount of income you can withdraw over your lifetime. This is called the sequence of returns risk.
When you're retired, you need to sell investments periodically to support your cash flow needs. If the negative returns occur first, you end up selling some holdings, and so you reduce the units you own that are available to benefit from any later occurring positive returns.
If you had retired back in 2000 just before the markets crashed, it would have taken you more than five years to get back to the original value of your investments. And while you’re in retirement, you’ll more than likely require a regular income from your pension which will effectively consolidate investment losses. You’re ultimately locking in losses when you sell your investments that have lost money, and this is even more difficult to recover from.
Do you have a question? Email us at firstname.lastname@example.org.
It is important that no actions should be taken without first taking advice. Personal circumstances and an individual’s appetite for risk means that the advice for one person may not be the same for everyone. Reeves do not advise on Defined Benefit pension schemes. Reeves do introduce a third party specialists in areas of work we do not cover. Reeves run an advanced investment portfolio management service on an advisory basis only