The Good, the Bad and the Ugly of Pension Drawdown
Older pension savers are used to a system that didn't allow many options for retirement. Younger savers have considerably more flexibility in their retirement planning thanks to new options, including pension drawdown. What should be understood is that there are no black and white rules that govern how pension funds are accessed. Pension saving and retirement are very personal and individualised.
Even within pension drawdown, different rules affect savers in different ways. Those rules notwithstanding, pension drawdown does have its good, bad, and ugly points to consider. That is what will be discussed in this guide. Should you have any questions, please feel free to contact us for assistance.
To get started, let us first define what pension drawdown is. Pension drawdown is a strategy whereby a pension saver, rather than converting a pension pot to a lifetime annuity, leaves the money in the pot and gradually draws from it. In the past, savers could choose capped or flexible drawdowns. Those options are no longer available for new contracts, as both have been replaced by the flexi-access drawdown.
The first on our list of good points is the flexibility that pension drawdown affords. If you recall, former chancellor George Osborne referred to flexible drawdown as a way of using a pension pot a lot like a bank account. His claim is genuine to a certain extent. With a flexi-access drawdown, pension savers can take as much or as little out of their pension pots as they see fit over a given period of time. They can also continue contributing to their pots in order to maintain maximum earning power. Thus you have 'deposits' and 'withdrawals' just like a bank account.
This means a pension saver could begin drawing from a pot at the age of 55 to provide either full or supplemental income. From his/her combined income, he/she could continue making pension contributions just as he/she would outside of drawdown. Whatever money is withdrawn can be used for everything from paying monthly bills to enjoying a better lifestyle.
Another very good benefit of new drawdown rules is that savers can take a lump-sum payment of up to 25% completely tax-free. There are lots of possibilities to consider with this. For example, let's say you have a substantial pension pot with some £200,000. You could withdraw £50,000 upon entering a drawdown contract, pay no tax on it, and immediately steer it into other investments with a higher earning potential.
Alternatively, let's say you have an interest-only mortgage that will come due in the next several years. You could use your 25% cash lump sum (provided it's large enough) to settle that mortgage rather than having to sell your house. You would then have a debt-free asset you could use to enhance your retirement income if necessary in the future.
The point of changing the drawdown rules was to give pension savers more flexibility. They have done just that. Still, a drawdown contract does have some disadvantages.
In order to give pension savers more flexibility, the government essentially eliminated the two types of drawdown contracts that were previously available. This is one of the bad points. Let's start by talking about the capped drawdown.
The capped drawdown enabled pension savers to gradually draw down their pensions with an annual cap calculated as a percentage of an amount established by the Government Actuary's Department (GAD) every year. It was a good option for people who want to draw down but do so with limits in place so as to prevent running out of money.
Although pensioners already participating in capped drawdown contracts can continue doing so with very few interruptions, these contracts are no longer available.
As for the previous flexible drawdown scheme, it was replaced by what we now call the flexi-access plan. This new plan is very similar in that pension savers can withdraw as little or as much as they like over a given period of time. But certain conditions apply.
First are the tax implications. As we mentioned earlier, you can take a 25% cash lump sum completely tax-free. You can also continue contributing to your pension pot even while drawing down. But if your initial lump sum exceeds £25,000, or you receive additional payments in that first year over and above your 25% withdrawal, any future contributions you make to your pension will be subject to the £10,000 annual allowance. In other words, any additional contributions in excess of £10,000 will still be subject to income tax.
The other tax implication relates to the income you receive every year as a result of drawdown. It is considered normal income and taxed at your marginal rate. Therefore, drawdown income has the potential of pushing you into a higher tax band if you are already on the upper edge.
The last thing to consider under the 'bad' category is the reality that withdrawing from your pension reduces the amount you have invested. Why does this matter? Because the less you have invested, the lower your earning potential. Let's do some simple maths as an illustration.
Assume you have a pension pot worth £100,000 making 5% annually. At the end of a full year, your pot would be worth £105,000. You will have earned £5,000. But let's say you took out a cash lump sum of £25,000. Earnings on the remaining £75,000 would leave you with a total of £78,750 after one year. You will have sacrificed £1,250 in earnings simply by having less money in your pot.
With every investment, some risks need to be considered. Some of those risks are serious enough to be considered 'ugly' by investment and retirement professionals. So what are the serious risks of pension drawdown?
The first is the very real risk of running out of money before you die. The whole point of the capped drawdown contract was to mitigate this risk. But now that the capped drawdown is no longer available pension savers choosing to exercise flexi-access drawdown have to be very careful about how much they take and when they take it.
Next, a primary motivation for choosing pension drawdown is to take money out of a scheme that's not earning much and put it into more lucrative investments. Why would someone do this? Usually, it's because a pension pot is not projected to have enough to provide suitable retirement income if left alone, requiring more aggressive investments to bring its value up.
The risk here is obvious. High-risk investments do offer the potential for higher returns, but the risks of losing substantially are also higher too. One of the most serious risks of using flexi-access drawdown to fund more aggressive investments is the potential of losing everything you take out of your pot.
It goes without saying that anyone thinking about such a strategy should seek sound advice first. It is important to fully know your current financial position, projections for the future, and all of your options for securing retirement income before you make a decision.
Finally, under the 'ugly' category is the risk of falling prey to the temptation to retire early because you think you have enough money to support yourself for the next several decades. Listen, looking at a pension pot worth several hundred thousand pounds makes early retirement rather tempting. But that amount of money can be deceiving.
How much do you currently spend just to pay your regular expenses? If you require £25,000 annually to live on, a £300,000 pot is only going to last you 12 to 15 years. Retiring at the age of 55 means you could run out of money before you reach 70. That's how you have to look at a drawdown contract.
Where Do You Stand?
Changes to pension drawdown rules have been mostly good in that they have given savers more flexibility in accessing their pension pots. But making the best use of a drawdown contract requires careful planning that takes into account a list of very specific factors, including:
- current financial circumstances
- current and projected debt load
- individual health
- ownership of property
- life insurance benefits
- state pension income.
Pension freedoms affecting everything from drawdown to lump sum payments have definitely changed the landscape for saving and retirement. If you are an older worker preparing to retire within the next few years, now is the time to seriously consider how you will access your pension pot when that time comes. If you are a younger worker, you still have time, but you should make the most of that time by sitting down with a financial adviser and creating a workable plan.
As always, please don't hesitate to call us and book a free consultation with one of our FCA-regulated pension experts. We will provide you with initial advice absolutely free, after which you can determine whether you want to avail yourself of the products and services we offer. You can also combine free government guidance with the advice you receive from us.
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