Five years since government reforms kickstarted the income drawdown revolution, pension savers are taking advantage of the opportunities in large numbers
The so-called pensions freedoms, which took effect in April 2015, allowed people in defined contribution (DC) pension schemes to access their pension from age 55 without suffering hefty tax penalties. Up to 25% can still be taken tax free, with the remainder now taxed at the saver’s marginal rate of income tax instead of the previous 55%.
The reforms have had wide-ranging implications. One that quickly became evident was that for people approaching retirement, a course of action that was previously relatively niche was now a clear favourite – income drawdown.
By allowing savers to leave their pot invested and draw an income from it as and when required, drawdown offers income flexibility in retirement and the potential to continue growing your pension.
Prior to 2015, more than 90% of pension savings were used to buy annuities. Now, twice as many drawdown plans are sold as annuities.
Yet unless drawdown is managed properly, well-laid retirement plans risk going awry. After all, it is hard to work out how much income you can safely take from your pension while ensuring it lasts as long as you need.
“The changes have huge benefits for tailoring income to individual situations and needs,” says Fiona Tait, technical director at Intelligent Pensions. “However, it also means there are effectively no brakes on the rate of withdrawal and an inexperienced investor could easily withdraw too much, too soon.”
So how do you ensure you enjoy the benefits of drawdown without suffering too many of the downsides?
Know what you want
It is important to understand what you are getting into and whether it is suitable. While it is now the mainstream option, drawdown is not appropriate for anyone who is risk-averse – for example, if the thought of your fund losing value keeps you awake at night or you only have a modest pension.
If that sounds like you, an annuity may be more suitable for either part or all of your pension fund, as it will provide guaranteed income throughout your retirement.
But if you want a certain amount of flexibility and control, you have a substantial pension – advisers suggest at least £100,000, ideally £150,000 or more – and the potential for your pot to keep growing, then drawdown may be the way forward.
Five drawdown dangers and how to avoid them
1 Running out of money: your pot may be needed for 30 years or more these days, so it can be easy to run it dry prematurely. If it is your main source of retirement income, you need to be particularly careful about the risk you take and the level of income you draw from it. One way to mitigate this is to take income from the income-producing elements of your portfolio, such as dividends and interest from bonds, rather than from the capital invested for growth.
2 Pound-cost ravaging: this is what happens to a portfolio when income is taken from it even as it is losing value when stock markets fall. Relying on ‘natural income’ – such as dividends and yields – can help to reduce this risk.
3 Scams: an estimated £200 million was lost in 2018 to pension scams such as ‘free pension reviews’ that persuaded people to invest in unsuitable, high-risk and unregulated investments. The FCA’s ScamSmart website, FCA.org.uk/scamsmart, offers tips on how to avoid scams, such as checking its register to ensure that anyone offering you advice or other financial services is FCA authorised.
4 Losing out on valuable benefits: billions has been transferred out of defined benefit (DB) schemes by savers wanting to take advantage of the pension freedoms. But many have missed out on generous retirement benefits as a result, such as guaranteed income. If you have a transfer value north of £30,000, you will need advice. Make sure you do your research carefully and check that your adviser is FCA regulated. They should start from a position that a transfer is unsuitable and be able to present evidence to the contrary if a transfer is recommended.
5 Falling foul of the taxman: many savers are unaware that while they can take 25% of their pension tax-free, the rest is taxed at their marginal rate – an oversight that has landed many with painful tax bills. Taking too much income from a drawdown plan can also have tax implications. Again, professional advice and/or impartial guidance (such as that offered by the Money and Pensions Service) can be invaluable here.
How long is a piece of string (or your retirement)?
Working out how much income can be taken from a drawdown pot, while ensuring it will last for as long as it is needed, is crucial but far from easy, particularly for those who are not taking advice. That might explain why more than four in 10 drawdown investors are taking out more than 10% of their fund a year, according to the FCA.
“Most people underestimate how long they will need their income for – that is how long they will live – and are unlikely to be able to identify a realistic level of long-term income which is capable of lasting for as long as they need it,” Tait points out.
The crucial point here is to keep in mind that any income taken out of a drawdown fund can reduce the size of the pot and how long it will last for.
This might not be a problem if markets were to rise steadily throughout your retirement – but that is highly unlikely, warns David Reid, chartered financial planner at Sutherland Independent.
“When we are projecting drawdown plans the primary risk is they run out of money. While we can use relatively conservative annualised assumptions, the reality is that markets go down as well as up."
Get your investment strategy right
Making your pot last as long as you need will depend largely on your investments.
“The key difference between investing up until retirement and investing afterwards is the need to cater for regular withdrawals of money,” says Tait. “This means at least some of the fund must be accessible and available to be cashed in when required.”
Some investors divide their portfolio into short- and longer-term ‘buckets’, with income taken from the lower-risk and more liquid investments in the short-term bucket.
A less structured approach is to set up a multi-fund diversified portfolio and withdraw income from the funds that achieve the greatest growth. The logic here is that income is taken from the funds most likely to grow sufficiently in value to offset the capital that has been removed.
Multi-asset funds, which offer one-stop-shop diversification, have a role to play too, according to Tom Munro, owner of Tom Munro Financial Solutions, near Falkirk.
“The many multi-asset strategies out there offer quarterly income while aiming to preserve capital over time,” he says.
He uses several multi-asset funds that all pay a natural income of around 4.5%, including Franklin UK Equity Income, Janus Henderson Income and Growth, and Saracen UK Income.
“This is more favourable than drawing down a fixed amount (say, 5%) as income, which can be problematic in times of volatility due to pound cost ravaging,” he adds. This describes the depletion of capital that can occur when investors don’t reduce the income they take from their pot when stock markets are falling."
Safe withdrawal rates
The safe withdrawal rate is the amount of money you can take from your fund to ensure that you do not run out of money. It’s widely believed that 4% represents a sustainable level of income.
However, investment data firm Morningstar has estimated that 2.5% to 3% is a more sustainable level of income withdrawal, when fees and lower expected future returns are factored in.
Build a toolkit
The various challenges faced in setting up and managing drawdown can make it difficult to do without support. Fortunately, a raft of resources is available even for those who don’t seek advice.
Most pension companies and investment platforms offer tools such as portfolio builders, risk questionnaires and various calculators. These can help you get an idea of the income your pot will generate and how much you can ‘safely’ withdraw.
Once a plan has been set up, you can also use your pension provider’s software to manage and monitor progress and ensure that you remain on track.
There are good non-commercial sources of information, guidance and planning tools too. Your first port of call should be the Government’s Money and Pensions Service.
Most investment platforms and pension providers will also offer fund or portfolio recommendations, based on broad risk profiles. You may also want to check the fund recommendations from our independent financial advisers.
These can help narrow down your choices. But it is important to remember they are just suggestions – they are not necessarily the most suitable for you, and performance cannot be guaranteed. Use them as a starting point for your own research rather than relying on them altogether.
Some platforms – such as Bestinvest and Hargreaves Lansdown – also offer ready-made investment solutions.
Offering a more bespoke service are so-called ‘robo-advisers’, including evestor and Nutmeg. These platforms offer an automated service that uses risk profiling, suitability questionnaires and decision trees to help investors work out their appetite for risk, producing a low-cost portfolio usually made up of ‘passive’ investments such as trackers and exchange traded funds (ETFs).
Although this is a straightforward and low-cost option (Nutmeg’s portfolios start at just 0.45%) for those who don’t fancy the headache of researching their own investments, there are limitations to robo-advisers.
They fall a long way short of offering full advice or being able to put together a portfolio entirely suitable for your needs, as they don’t typically take the bigger picture into consideration (such as objectives, tax, family circumstances and other income sources).
Remember that when advice is unregulated, you don’t have recourse to the Financial Ombudsman service – and very few robo-services are regulated advisers.
Invest in advice
Almost four in 10 drawdown plans are being taken without financial advice, according to the Financial Conduct Authority (FCA), up from just 5% prior to 2015.
But professional advice is perhaps the best way to reduce the risk of drawdown. Most advisers will put together a personal cashflow plan based on your specific income requirements and likely life expectancy. They will also build and manage your investment plan and highlight the most tax-efficient way of taking income from drawdown, which is not as straightforward as it initially appears.
This process will only be started after a full fact find too – meaning your adviser is able to get to know you and get a good understanding of your priorities, not to mention your personal circumstances.
There is an additional advantage of protection. If something goes wrong, you have recourse to the Financial Ombudsman Service if you took regulated advice. That isn’t the case when it comes to unregulated advice or the various generic information and guidance services.
The cost of advice can vary significantly from firm to firm.
“For implementing the full lifetime financial plan, firms tend to charge around 0.75% initial fee, and the same ongoing annual amount,” says Munro.
An adviser will also make sure you avoid some of the more costly drawdown mistakes.
“Going it alone too often leads to serious losses due to the wrong asset allocation and no regular portfolio rebalancing to minimise risk,” says Munro.
What is the FCA doing to reduce the risk of drawdown?
The regulator is looking to increase guidance options for investors that don’t use advisers. It now requires pension providers to send ‘wake-up packs’ to their customers ahead of their planned retirement age to highlight the advantages of taking financial advice and signposting them to the Money and Pensions Service.
From April 2020, new FCA rules will also see non-advised investors entering new drawdown arrangements being offered investment ‘pathways’ based on different investment goals.
The four pathways will be built on the following objectives:
Option 1: I have no plans to touch my money in the next five years;
Option 2: I plan to use my money to set up a guaranteed income (annuity) within the next five years;
Option 3: I plan to start taking my money as a long-term income within the next five years;
Option 4: I plan to take out all my money within the next five years.
Pension providers will offer one investment solution for each objective, with the broad aim being to help simplify the investment decisions facing non-advised investors at retirement.
This article was first published in our sister publication How To Retire In Style.