Before the new pension and tax rules (April 2015), the only real choice at retirement was an annuity. The introduction of flexi-access pension drawdown gave those over 55 more control over their pension fund.
Several economic factors have driven down the value of annuities. The benefits of pension drawdown can make it an attractive alternative but it is not without risk.
What Is Pension Drawdown
Flexi-access pension drawdown allows you to transfer one or more existing pensions into an investment (Drawdown) pension fund. You can access your drawdown account to fund your retirement. 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 grow older.
It is your responsibility to manage the pension fund as an investment to ensure it lasts a lifetime. 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.
Existing pension arrangements may not offer a drawdown option and it may be necessary to transfer to a different pension fund. Some drawdown arrangements do not offer the same level of flexibility as others and may not be suitable for everyone.
Consider Your Pension Options
Any decision to enter pension drawdown (or not) must be taken as part of a retirement planning exercise. You may have several pensions, some active and some frozen. Some of those pensions may offer valuable benefits and be best left where they are. ISA’s and other investments should be considered as part of the mix. You may wish to use part of your total pension funds to buy an annuity to provide a level of regular income. There is lots to consider.
A quick review of information on the internet will show that estimates vary wildly on what an individual may need as a retirement fund. There is a level of scaremongering with some stating that a pension fund of £1m is required to fund a reasonable standard of living in retirement. That may be true for some but not the vast majority of the population. The reality depends on individual circumstances.
The key issue when considering drawdown is drawings from the fund and how and when those drawings are taken. Longevity rates are increasing and it is important to ensure pension funds do not run out in retirement.
Pension Drawdown Benefits
Pension Drawdown is a flexible solution with a number of benefits over its chief competitor, an annuity, these include:
- You have significantly improved control.
- You may withdraw what you want when you want.
- You have greater control over remaining pension fund distribution to beneficiaries after your death.
- The fund is invested and can continue to grow.
- You control the amount of risk you are prepared to take.
- There are potential tax planning advantages.
When you buy an annuity you purchase a set monthly income for life. As with drawdown, you may take up to 25% of the pension fund as a tax free sum with the balance funding the annuity. The pension income from an annuity is fixed. It cannot be varied up or down to deal with any specific circumstances that may arise. Annuities can be set up with other options, such as spouses pension, but it must be selected at outset and each option comes at a cost.
When you set up a drawdown arrangement you may take up to 25% of the total transferred pension fund as a tax-free lump sum. You may schedule this tax-free amount in some way perhaps taking 15% initially and 10% at some later date.
If you are a member of several defined contribution pension schemes 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. 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 of 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 of each option.
Death And Your Beneficiaries
One of the potential benefits of flexi pension drawdown is the ability to pass any remaining pension fund on your (and your Spouse’s) death to beneficiaries without an inheritance tax charge. With an annuity, the pension will die with you unless you selected an appropriate option (with an extra cost) at the outset.
The pension drawdown rules vary according to the pension holder’s age at death. Should you die before age 75 your nominated beneficiary 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.
Or any combination of the above, all tax-free.
Should you die after age 75 the options are as stated above but tax is payable on any income received from the drawdown fund at the beneficiary’s marginal tax rate (20, 40 or 45 percent depending on their income in the tax year).
Increased control over your pension is one of the potential advantages of pension drawdown. Instead of a faceless fund manager in control of your (and many other individuals) pension funds with Drawdown 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.
You may decide to take more (or less) risk than a general fund depending on your circumstances. As circumstances change over time you may decide to change your exposure to risk and/or re-balance your investment portfolio over time.
You will notice that tax is in both the potential advantages and disadvantages list. By managing when pension pots are taken into drawdown and tax free sums it is possible to limit the amount of tax you will 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:
- There is a 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.
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. Withdrawal rates, 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 scenario analysis (If ‘X’ happens what will be the potential result).
Investment And Management Issues
Trying to build a solid plan is difficult (you don’t know when you will die). 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 fund investment options including a Self Invested Personal Pension (SIPP), passive and active funds. The performance of your funds can often be viewed and managed via a platform (an online software product).
The selection of appropriate funds and platforms 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.
As an example where a fee is applied as a percentage of the total fund, an increase of just 0.5% in that fee can result in tens of thousands of pounds of lost investment value over a 25 year period.
It is, of course, possible to make appropriate choices and set up the drawdown arrangement in full yourself. However, the potential for loss if incorrect 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 and is capped at £40,000. This is known as the annual allowance.
At the point, first income is taken from a drawdown account the tax relief limit falls to £4,000. This limits your ability to top up your pension fund if you do have the funds available.
It is 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 continue to receive 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 £1.03m) 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.
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 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 drawings 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 some action is required.
Markets and the value of the various classes of assets move up and down on a continual basis. Watching the value of investments move on a weekly (or worse a daily basis) is counterproductive. But watching for trends over the longer term allows you to take action
Do You Need A Adviser
To make an informed choice between personally researching and implementing a pension drawdown arrangement or taking pension drawdown advice (with an associated cost) there are some basic questions to answer, 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 wrong decision is made?
- How likely is it I will make that wrong 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. Pension drawdown is not without risk but with the value of annuities still recovering from a all time low its benefits make it worth serious consideration.
Should you wish to talk through your options (with no obligation) give us a call on 0800 043 8341 or Email email@example.com.
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The information in this article does not constitute financial or other professional advice. The value of investments can go down as well as up and you may not get back the full amount you invested. The past is not a guide to future performance. 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. Any tax rates mentioned in the post refer to England and Wales only. The rates in Scotland may differ.