What is drawdown?
The pension freedoms introduced in 2016 mean more investors can keep their pension funds invested in retirement and draw out money as they need it, instead of buying an annuity that guarantees them an income for life. An individual moving into pension drawdown can usually take up to 25% of the amount tax free and decide where to invest the rest, taking a variable income from the pension when they choose.
Compared with the relatively low income on offer from annuities, drawdown offers extra flexibility and the potential for better returns and more income from a pension pot. However, it is also a risky option. Keeping a pension fund invested, for instance in a SIPP (or Self Invested Personal Pension) means the value can fluctuate according to what markets are doing. Care needs to be taken about how much is drawn to ensure there is enough left for future needs.
The following provides an illustration of some possible drawdown approaches. A drawdown fund, and therefore any income, is not secure and is not guaranteed. In adverse market conditions, or in the event of poor investment decisions, you could get back less than you originally invested. Your fund could be significantly (or even completely) eroded leaving little or nothing to provide income or buy an annuity for you or your beneficiaries later in retirement.
DRAWING FROM CAPITAL
Drawing from capital means taking fixed, regular amounts, or irregular amounts, to meet specific needs. This gives assurance of the required level of income in the short term. However, it means selling investments to generate cash to pay the pension income.
Taking capital from investments when they are falling in value can compound losses and leave less for future growth, and the value of the portfolio can be quickly eroded. This is especially the case with higher risk investments, which can be more volatile (the extent to which the price goes up and down).
The pot could run out earlier than expected and to adapt to changing circumstances action may be required such as reducing income, changing the investment strategy or buying an annuity with some or all of the fund.
DRAWING FROM CAPITAL WITH CASH BUFFER
To help counter this reduction in capital, it may help to invest part of the portfolio in income-producing assets such as corporate bonds and dividend-yielding equities and allowing this to accumulate to build up a cash buffer to help make withdrawals. This may mean that ill-timed investment sales can be avoided.
Keeping a permanent cash buffer as part of the drawdown portfolio could also help avoid the problems associated with the mechanical selling of investments to fund withdrawals. However, keeping money in cash usually has a detrimental impact on the portfolio’s ability to sustain income over the longer term.
There could be circumstances where a permanent cash reserve could prove worthwhile, but because the portion in cash generates little or no return the overall performance potential of the portfolio is likely to be reduced.
DRAWING THE NATURAL YIELD
The natural yield is the income generated by investments - usually dividends from shares, or interest paid by bonds, either held directly or through a fund. Taking the natural income has the advantage that ‘sequencing’ risk – the danger of encashing investments at inopportune moments during a period of market weakness – is effectively eliminated.
The drawback is that income from investments is variable and not guaranteed. If the amount of income is important and needs to be a regular amount each year, this strategy may not appeal.
TAKING NO INCOME
There is no requirement to take an income from a drawdown pot if it is not needed or wanted. An investor’s investment strategy, and the balance between risk and potential return, will depend on if and when an income is needed and how it is to be taken.
For example, if you plan to purchase an annuity, it could be wise to start gradually reducing investment risk as intended purchase date gets nearer, for instance by moving more of portfolio into cash.
If an income isn’t planned until much later in retirement a more adventurous approach may be appropriate, incorporating higher risk investments with higher return potential. However, with increasing longevity retirement can last decades, and the pot could run out if the investments chosen perform badly, so it’s important to take a measured and diversified approach.
TAKING A HIGH INCOME
Some investors may wish to take high withdrawals from drawdown plan because they are not dependent on this money and have adequate income from elsewhere. However, remember that withdrawals are subject to income tax and, if not spent or gifted, may also be subject to inheritance tax when you die.
Taking the whole or a large amount out may be appealing but you should think about tax, particularly if it could take you into a higher income tax bracket. You also need to ensure you have enough income to last your entire retirement, however long this is, and account for health and care needs and any other changing circumstances.
If you are looking to withdraw your entire fund over a period of less than five years and can’t afford for the fund value to fall too far, you might stick to low risk investments, notably cash. This would avoid significant potential falls in the value of the pension pot.
No one approach to drawdown works best. It all depends on an individual’s circumstances and objectives as to which one, or a combination, is suitable. Success is also contingent on employing an appropriate investment strategy for the approach taken. Attaining sufficient return while minimising volatility is important, particularly for those taking withdrawals from capital.
Remember too that while drawdown offers great flexibility and the chance to increase income it isn’t right for everyone. Investments can fall and you might get back less than you invest. If you do not have sufficient secure resources to cover your essential expenses, or you cannot accept that your income could fall, or even run out, then drawdown is unlikely to be for you and an annuity should be considered.
Given the complexities involved we recommend you understand your options and ensure your chosen route is suitable for your circumstances. If you are at all unsure, take appropriate advice or guidance. The government's Pension Wise service provides free impartial guidance on your retirement options, while an regulated financial adviser can help create an effective drawdown strategy and asset mix for an individual’s needs. Get in touch with a Charles Stanley Financial Planning consultant here.
The taxation of pensions depends on personal circumstances and is subject to change in future.
This article is solely for information purposes and does not constitute advice or a personal recommendation. The taxation of pensions and the rules surrounding them could change in the future. If you are unsure as to whether an investment or a pension is suitable for you, please seek professional financial advice.