Before the new pension and tax rules (April 2015), the options available at retirement were limited and you could only access your benefits in a way prescribed by your annuity provider, or the Government Actuary’s Department through what is now known as “capped drawdown”. The introduction of flexi-access pension drawdown added another retirement option to the mix.
What are the benefits of pension drawdown? How does it compare to an annuity and what are the key risks to consider?
What Is Pension Drawdown
Flexi-access pension drawdown allows you to transfer one or more existing pensions into an arrangement that allows you to access your pension benefits in a way that you choose. This may be in the form of tax free lump sums, taxable income or a combination of the two.
You can drawdown from the fund as you wish, potentially taking more in the early years of retirement, reducing income as you get older and spend less. It is your responsibility to manage the pension fund as an investment to ensure it lasts a lifetime.
Existing pension arrangements may not offer a drawdown option and it may be necessary to transfer to a different pension plan . Some drawdown arrangements do not offer the same level of flexibility as others and may not be suitable for everyone.
It is important to note that flexi drawdown only applies to those with defined contribution pensions (not final salary pensions). To access the benefits of pension drawdown requires a final salary pension transfer to an appropriate defined contribution scheme. This is not something to attempt without detailed consideration of the risks involved.
The Alternatives To Pension Drawdown
The main alternative to pension drawdown is an Annuity. This will (usually) pay a guaranteed fixed monthly income throughout your lifetime. You will need to decide if you wish to trade this lifetime guarantee for the potential benefits (outlined below) that pension drawdown offers.
We suggest any decision to enter pension drawdown (or not) should be taken as part of a retirement planning exercise. You will need to work out how much you will have in your retirement fund and how much income you will need in retirement. Then, compare what you can expect to receive from an Annuity with what pension drawdown may offer.
The key issue when considering drawdown is how much to take from the fund and when you take it. We are all living longer so it’s important to ensure that your pension fund doesn’t run out before you do!
Pension Drawdown Benefits
Pension Drawdown is a flexible solution with a number of benefits
- You have significantly improved flexibility.
- You can withdraw what you want, when you want.
- You have greater control over how the remaining pension fund is distributed to beneficiaries when you die.
- The fund is invested and can continue to grow.
- You decide the amount of risk you are prepared to take.
- There are potential tax planning advantages.
When you buy an annuity you usually purchase a set monthly income for life. As with drawdown, you can take up to 25% of the pension fund as a tax free sum with the balance funding the annuity.
Once the annuity starts the benefits are fixed. You cannot vary the income up or down to deal with any specific circumstances that may arise. Annuities can be set up with other options, such as spouses pension and guaranteed periods, but these options must be selected at outset and each one will reduce the level of income that you will receive i.e. they come at a cost.
You may move some (or all) of your pension pots gradually into income drawdown. You can take up to 25 percent of each pension pot you move tax-free. If you do select the 25 percent tax-free option the balance of the pension fund is invested in a drawdown pension fund.
You may make withdrawals from this fund as you wish but it is important to be aware of the risks. You might decide to withdraw more in the early years of retirement and reduce your income as your needs change in later life.
Alternatively, at the point of taking your pension, you may decide to take Uncrystallised Funds Pension Lump Sums (UFPLS) as an alternative to the one off 25% tax-free lump sum.
If you select the UPPLS option then 25% of each withdrawal you make will be tax-free with the balance taxed at your marginal tax rate. It is important to carefully select between the 25% tax-free lump sum and the UFPLS. The decision you take can have a major impact on how long your pension fund lasts into retirement. It is also important to consider the tax implications and the impact on any future pension contributions that you or your employer might make.
Death And Your Beneficiaries
One of the potential benefits of pension drawdown is the ability to pass any remaining pension fund on to your beneficiaries when you die without an inheritance tax charge. With an annuity, the pension will die with you unless (at outset) you selected one of the options mentioned earlier in this post.
Your beneficiaries may:
- Take the pension fund in full (or in part).
- Take income from the existing pension drawdown arrangement.
- Use the drawdown pension fund (in part or full) to purchase an annuity.
Your beneficiaries tax position on anything they take from the fund varies depending on your age at death. If you die before age 75 then anything they take from the fund will be tax free, after age 75 they will be taxed on withdrawals in line with any other income that they have taking account of their personal allowance and tax rates applicable to them.
Increased control over your pension is one of the potential advantages of pension drawdown. You can look after the pot yourself, appoint your own fund manager or engage an adviser to help. Essentially you take control.
You (and/or your financial adviser) decide on the returns you wish to target, the risk you wish to take and the makeup of your portfolio. This is not without risk (see below) but it does allow you to manage your investments according to your individual plan and your specific needs.
As your circumstances change over time you may decide to reassess your exposure to risk and/or re-balance your investment portfolio.
You will notice that tax is in both the potential advantages and disadvantages list. By using the full flexibility on offer with drawdown it is possible to limit the amount of income tax that you pay.
For some appropriate management of Uncrystallised Funds Pension Lump Sums can minimise their tax exposure. This is a complex subject and it is important to consult a qualified financial adviser.
Pension Drawdown Risks
There are also significant risks with pension drawdown, these include:
- The risk of running out of money in retirement.
- Poor investment decisions could result in your pension fund dwindling rapidly.
- You need to actively manage your investments, or pay someone to do it for you.
- Investment returns can go down as well as up.
- Annuities are simple to understand and need minimal management. In contrast, drawdown can be difficult to understand and mistakes can have major consequences.
- Tax implications.
- You could be tempted to take more than you need.
Running Out Of Money In Retirement
We have written about the risks of running out of money in retirement in detail elsewhere on this blog. How much you take, market risks, withdrawals in a period of market downturn and fees and charges are all areas that require careful consideration.
A well thought out plan is essential. As a minimum, you need to model what income you are likely to need and when, the investment growth you expect and the potential impact of inflation. You should also run some cash flow modelling scenarios (If ‘X’ happens what will be the potential result).
Investment And Management Issues
Trying to build a solid retirement plan can be difficult. However, drawdown delivers the flexibility to modify your investment portfolio to match changing circumstances. If you do not have the time or inclination to manage your investments or you are risk averse then drawdown may not be the best choice.
There are various pension drawdown investment options including passive and active funds. These funds can be accessed through Self Invested Personal Pensions (SIPP) or a regular Personal Pension arrangement. The SIPP option gives you greater scope to select your own investments such as shares and direct holdings in corporate bonds.The performance of your funds can often be viewed and managed via an online investment platform or fund supermarket LINK .
The selection of appropriate funds and platform is essential if you are to maximise the returns on your pension fund investment. It is also important to keep a close eye on fees. The level of fees may seem low in percentage terms and therefore, seem trivial but the cumulative value over an extended period of up to 25 years can be significant..
It is, of course, possible to make appropriate choices and set up the drawdown arrangement in full yourself. However, the potential for loss if poor choices are made is significant and it is often best to employ a financial adviser (more below).
The amount you can invest in a pension and receive full tax relief depends on your earnings for the year but in any event is capped at £40,000, although in some circumstances unused allowance from previous tax years can be brought forward. This is known as the annual allowance.
If you take any income from a drawdown account the Money Purchase Annual Allowance (MPAA) will apply this restricts the contributions that you can make (that attract tax relief) to £4,000 each year. This reduction in the amount that you can contribute is significant and careful consideration needs to be given to any withdrawal that you make. If you take tax free cash only the MPAA does not apply. For some individuals with large pension pots, the lifetime allowance may also be a concern.
Successive Governments have a history of changing tax percentages and limits. It is therefore important to keep up with the latest legislation or use an appropriate adviser.
If, after considering both the benefits and risks drawdown remains your preferred choice there are ways of reducing risk. Taking a part time job or having some form of income can both reduce the need to draw on your pension fund and give you an extra source of cash in emergencies.
Keeping a close eye on your portfolio of investments on a quarterly basis will allow you to spot any negative trends and consider (after consulting your adviser if you have one) if any action is required.
Markets and the value of the various types of investment you will hold in your pension fund move up and down on a regular basis. Watching the value of investments move on a weekly (or worse a daily basis) is often counterproductive. But watching for trends over the longer term will allow you to plan an effective strategy.
Do You Need An Adviser
To make an informed choice between personally researching and implementing a pension drawdown arrangement or taking pension drawdown advice (with the associated cost) there are some basic questions to ask yourself, including:
- How capable am I of understanding the key issues and making decisions?
- Do I have the time/inclination to take on the task myself?
- What is my attitude towards risk and loss?
- What is the maximum potential for capital erosion if a poor decision is made?
- How likely is it I will make that poor decision?
- How does the potential for capital erosion compare with the cost of financial advice?
- If I take advice how can I be assured the advice will be of high quality and better than the information I may collect from published sources?
- What is the availability of high quality financial advice. Will I be able to find a suitable financial adviser?
Ultimately the decision depends on your personal circumstances and your attitude to investment risk.
Should you wish to talk through your retirement options then give us a call on 0800 043 8341 or complete the form below and we will call you back at a time convenient for you. If you have any questions Email us or use the Chat facility.
This blog is intended to provide a general review of certain topics and its purpose is to inform but NOT to recommend or support any specific investment or course of action. The past is not a guide to future performance. The value of investments can go down as well as up and you may not get back the full amount you invested. Tax and financial regulations can change. Any figures quoted above are correct at the date of publication.