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The case for Drawdown

Pension drawdown – your flexible income friend!

In the old days, before pension freedoms, most people converted their pension pots into income by getting a guaranteed income from an annuity and pension drawdown was only used by the more savvy and wealthy people.

But nowadays, pension drawdown has overtaken annuities to be the option of choice when it is time to convert your pension pot into cash and income.

What is pension drawdown?

A drawdown plan allows you to take the normal 25% tax-free cash sum and then you can take regular or ad hoc income withdrawals direct from your pension fund.

In many ways, this is similar to taking an income direct from your bank or savings account except your money stays inside a pension plan and you pay tax on any income paid out.

If your pension fund grows in value, you can increase your payments in the future but if your fund decreases in value you may have to reduce your income payments and at the extreme you could run out of money.

When you die the money remaining in your pension drawdown pot can be left to your beneficiaries. If you die before age 75 there will be no tax to pay but if you die after age 75 your beneficiaries will pay tax at their marginal rate on any money that is paid to them.

You can read and learn more about this on our website at toolbox.brgl.co.uk/drawdown .

Many shades of drawdown

The basic concept of drawdown may be easy to understand but the way in which drawdown is used in practice can be varied and complicated.

Although the default option may be to take the 25% tax-free cash and a regular income, there are many other different ways in which drawdown can be used:

Tax-free cash only but no income drawdown (NID) – If you only want to take your tax-free cash you will be technically converting your pension pot into a drawdown arrangement. You can then take any amount of income from your pension in the future, but you will be taxed at your marginal rate.

Ad hoc cash payments – Rather than having a regular income, some people prefer just to take a taxable cash sum when they need it e.g. to pay for a new car or holiday.

Taking regular slices of tax-free cash and income (salami slicing) – Instead of taking all of your tax-free cash in one go at the outset you can convert a slice of your pension pot and take 25% tax-free cash and 75% taxable income.

For instance, if you have a £100,000 pension pot you could take a £10,000 slice which would pay out £2,500 tax-free and £7,500 of taxable income.

This may seem overly complicated, but it is the most tax-efficient and flexible way to take income from your pension pot. If you would like to know more about salami slicing please go to drawdown/salami-slicing .

Combination of drawdown and annuities – If you want to combine the advantages of a guaranteed income with the option to leave an inheritance you can consider a combination of drawdown and annuities.

The case for drawdown

Pension drawdown is a popular and attractive way of converting your pension pot into cash and income because unlike an annuity you are in full control to make your own decisions. This means the advantages of drawdown include:

  • Income flexibility – you can take as much or little income as you need
  • Control of investments – you can decide where your pension is invested
  • Choice of death benefits – you can decide what happens to your pension pot after your death.

However, these advantages can quickly change into disadvantages unless the right decisions are made.

At the most basic level, the case for drawdown is that it appears you can have your cake and eat it too i.e. you can have an income from your pension pot but still have money to leave to the family.

At a more sophisticated level you can organise your retirement income to reflect your specific income needs as well as trying to grow your pension pot so that there is money to leave to the family.

But as we all know in reality you can’t have your cake and eat it so it is really important that you understand the trade-off between maximising your income and growing the fund so you can leave an inheritance. I will discuss this later.

Your income needs

Everybody needs income and you probably need more income than you think. Therefore, it is important to work out how much income you need to enjoy the lifestyle you are accustomed to and decide where that income will come from.

Most people will have three primary sources of cash / income when their income from work stops:

  • Cash, savings and investments
  • State pensions
  • Company / personal pensions

It normally makes sense to avoid running down your cash and savings when you first retire but it might make sense to take income from your investments depending on your circumstances. Your state pension and final salary pension (if you have one) will provide the bedrock of guaranteed income.

Your workplace or personal money purchase pensions can also provide a valuable stream of income when you need it but deciding when and how much income to take from your pension pots can be one of the most complex decisions in personal finance.

deciding when and how much income to take from your pension pots can be one of the most complex decisions in personal finance”

If you take too much income and run out of money later in life there will be nothing to leave to the family but if you don’t take enough income you may not enjoy retirement as much as you could have done but you will have money to leave behind.

This means that if you don’t make the right decisions you could squander valuable retirement income and your ability to leave an inheritance.

Finally, don’t forget about tax. Any money you take out of your pension pot (after taking 25% tax-free) is taxable at your marginal rate so make sure you don’t pay more tax than you have to, especially if you have to pay higher rate tax.

Leaving an inheritance

The most important difference between a guaranteed pension and a drawdown plan is that when you die all of the money remaining in your drawdown pot can be transferred to your family whereas with an annuity or DB the income will stop unless there is a dependence pension.

The rules for personal pensions, which includes SIPPs and drawdown’s, are as follows:

On your death any remaining money in your pension pot can be paid to your chosen beneficiaries as follows:

  • a cash lump sum
  • to purchase an annuity
  • be transferred to a new pension in the name of the beneficiary

If you die before the age of 75 your beneficiaries will have no tax to pay when they receive cash or income. But if you die after the age of 75 your beneficiaries will pay tax at their marginal rate on any money paid to them.

You can nominate anybody as a beneficiary such as your spouse or partner, children or grandchildren. You can even nominate a trust or a charity.

The death benefit rules are so flexible that you can use your pension or drawdown plan for estate planning purposes by making provisions to pass money down through future generations.

In my experience, many people place a high priority on inheritance planning when they first retire but as they get older it is not unusual for their priorities to change as they realise that they need to make sure they have enough money for their own retirement.

This explains why the case for annuities (where there is no inheritance) grows stronger as people get older.

Watch out!

There is no doubt that Pension Drawdown is a very attractive proposition, after all who wouldn’t want both an income and the option to leave money to the family after their death?

But drawdown, unlike annuities or a DB pension can be a risky business and there are a number of things you must watch out for:

  • Making sure your income is sustainable
  • Investment and sequence of returns risk
  • Avoid paying too much tax

Sustainable income

One of the most important questions for drawdown investors is “how much income should be withdrawn each year?”

Take too much income and there is a risk that you will run out of money but take too little and you will have lost out on income you could have spent during your retirement.

If you don’t want to withdraw too much or too little you will need to work out what is a sustainable level of income.

There are two parts to the sustainable income equation: sustainable in terms of not running out of money and sustainable by maintaining spending power i.e. keeping up with inflation.

In 1994, US financial adviser William Bengen worked out the safe withdrawal rate was 4% of the initial amount invested, assuming the income increased each year by inflation and the fund was invested 50% in equities and 50% in bonds. This became known as the 4% Rule.

In the UK, the 4% rule has been revised downwards to between 2.5% and 3.5% depending on assumptions.

This is a complicated matter, and you should get financial advice from a specialist adviser such as Better Retirement. You can find out more about sustainable income at drawdown/sustainable-income .

Investment and sequence of returns risk

You might be aware of the expression “investing before retirement is very different to investing after retirement” but what does this actually mean?

When you are saving for retirement you have both time and money on your side. Time to weather the ups and downs of the stock market and money to pay the bills and to pay into your pension.

When you retire things are different because you will be taking money out of your pension pot (drawdown) and if there is a stock market crash you may not have the time or money to ride out the storm.

Sequence of returns risk is the risk that investment returns are lower than expected (or even negative) in the early stages of drawdown resulting in capital being eroded quicker than anticipated. If this happens your drawdown fund may not be able to sustain future income payments and there is increased risk your income may be reduced or in the extreme, run out of money unless investment returns are higher than expected in the future.

There are a number of ways of investing in order to reduce the sequence of returns risk and a specialist adviser such as Better Retirement will advise you about this. Please see for more information drawdown/sequence-of-returns .

Avoid paying too much tax

It is not only income tax you have to worry about because you need to watch out for other tax traps such as the Money Purchase Annual Allowance if you are still making pension contributions or the Lifetime Allowance Charge if you have a large pension pot.

There is more information about tax on our website.

Conclusion

There is a very strong case for pension drawdown, built on the three pillars of: income flexibility, investment control and option to leave money to the family.

However, these three advantages can easily turn to disadvantages if you don’t invest your pension pot wisely or withdraw too much income at the wrong time.

Pension drawdown might appear to be a simple and easy to understand plan, but look under the bonnet and there are lots of complex and moving parts which have to be properly managed in order to avoid losing money or running out of income.

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