Pension freedom has offered millions more Britons a new way to take income in retirement: drawdown. But most remain unaware of both the potential benefits and the real risks attached. Neil Adams of Drewberry Wealth puts these pros and cons side by side to help you decide.
Income drawdown (often called just ‘drawdown’) is actually not new. It was first offered in the UK over 20 years ago to free pension investors from the straitjacket of annuities (where the pension pot is traded for a guaranteed income for life). Annuity rates were hardly generous at the time – but since then they’ve plunged to a 300-year low.
In fact, rates are now so low that many of the UK’s largest annuity providers have pulled out of the market altogether. This in turn has reduced choice and price competition – making the problem even worse if you’re looking for a retirement income.
Pension freedom introduced a new kind of drawdown – sometimes call ‘flexi-access’ drawdown, and made it generally available. The squeezed annuity market has made this option more attractive than ever – but as with everything, there are also downsides.
So let’s look at the positives and negatives of drawdown – the ‘plus column’ and the ‘minus column’.
In the plus column – the advantages of drawdown
1. Flexibility and choice
Modern drawdown schemes allow you to retain control over your pension pot and how it is invested. It also lets you access your pot in a way that is uniquely suited to you – e.g. a tax-efficient lump sum and flexible income payments.
2. Greater tax efficiency
Drawdown also gives you control over the level of income you take from your pension pot each year. This means you have a better chance of limiting the tax you pay on your retirement income.
This is something that those who chose to go the annuity route, or who receive benefits from a final salary pension scheme, can’t do. Instead they receive a set income each year, which when added to other sources of income (e.g. state pension, other pensions, earnings, dividends) could lift them into a higher tax band.
By contrast, with a drawdown scheme you can reduce your income from your pension pot if other sources of income might expose you to higher tax. This doesn’t necessarily mean living on less; it just means balancing your income below the critical level to maintain maximum tax efficiency.
Being able to fine-tune your pension income also makes it easier to utilise other tax allowances such as the £5,000 annual dividend and saving income allowances, or the £11,300 (for 2017/2018) capital gains tax allowance.
We estimate that couples who carefully monitor their pension income and tax allowances can enjoy a tax-free retirement income of over £60,000 a year – and that’s before any income they might have from ISA investments.
3. Passing on wealth
Drawdown is also one of the most tax-efficient ways to pass wealth down through your family. Pension freedom means you can now pass on any remaining pension wealth to your loved ones (previously there was a hefty 55 per cent ‘death tax’ – distinct from inheritance tax, which has never applied to pensions).
If you die before the age of 75, all your pension assets can be passed to your beneficiaries free of tax. They can choose to continue drawdown and enjoy the income tax free, or they can purchase an annuity, the income from which will also be free of tax.
If you die after age 75, your beneficiaries will be liable to income tax at their marginal rate on anything you might leave them, although they can choose to keep the funds invested and defer taking benefits until a more opportune time in their lives.
This ability to pass on your pension wealth has helped to trigger the current boom in final salary pension transfers. This is because, just like an annuity, a final salary pension will be lost once you (or in some cases, both you and your spouse) die.
So far, so good. But drawdown is not without its drawbacks.
In the minus column – the risks of drawdown
1. Running out of money
The single biggest risk of drawdown is that it’s possible to run out of money completely. In contrast to the guaranteed income of an annuity, drawdown income comes from a finite pension pot, and when that’s gone it’s gone. This means it is vital to plan carefully in advance – which brings us to the second drawback.
2. Greater responsibility
Another downside of drawdown is that it transfers the risks of delivering an income in retirement directly on to your shoulders. You must choose where and how your pension pot is invested, and how much to draw out each year. If you make the wrong choices – whether in your selected investments, or in how much you take – then your pension pot could shrink too fast and will run out too soon (see above).
3. Market fluctuations
Related to point 2 is the fact that your pot remains invested in assets than can go both up and down in value. Although you can reduce your level of risk, the overall performance of the market is not within your control. Drawing income during times of poor performance can make it progressively harder for an invested pot to recover its value, in a phenomenon known as ‘sequence of returns risk’. You therefore need to take particular care during periods when the market is falling.
These three drawbacks are not a reason to reject drawdown. But they are a very good reason to seek professional advice before choosing the drawdown option, and to consult an adviser regularly to ensure that your plans remain on track.
To help you understand the risks involved, Drewberry has created the Drewberry Pension Drawdown Calculator. This is a free online tool that calculates either how much you can afford to take in monthly income without depleting your pension pot, or how long your pot is likely to last based on your chosen level of income. You can also play around with it to see how large a pension pot you might need to deliver your ideal monthly income. The calculator provides projections based on annual fund performance of between 2 per cent and 6 per cent (actually performance may of course vary even more than this).
Which retirement option will give you peace of mind?
On the face of it, the thought of running out of money in retirement might put you off drawdown. Certainly if your priority is a guaranteed level of income, and you don’t like the thought of investment risk or just the responsibility, then an annuity (or final salary pension, if you have one) may still be your best option.
However, peace of mind comes in different forms. And if you end up regretting your poor-value annuity that you bought for the sake of a quiet life, that is unlikely to bring peace of mind. The same may be true of some who have final salary pension schemes. Although these may provide a guaranteed, usually inflation-linked income, they may also lead to higher tax bills than could be achieved with drawdown.
But the worst aspect of an annuity or final salary pension may be the fact that the benefits are lost upon death, and cannot be passed on to family. This compares very poorly to the prospect of transferring such benefits to a personal pension and making use of drawdown.
If properly managed, a drawdown pension pot could deliver the same income, if not greater, along with more flexibility and tax saving opportunities. And after death it may remain a significant financial asset that can be left to the next generation.
So it’s well worth taking the time to learn more about drawdown, and finding a good adviser who can help build a plan for you and your family.
You may also be interested in Drewberry’s free guide: Making sense of income drawdown.
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Neil Adams is head of pension planning at Drewberry Wealth Management.