Pension drawdown and the melting snowball

Living off an invested pension pot rather than buying an annuity could be a more flexible option for many people in retirement. The new freedoms make this possible – but no-one should underestimate the risks of running out of money. It could happen sooner than you think.

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At the risk of sounding like a stuck record, a pension is the best investment you can make. (If you can remember stuck records, this is even more relevant.) Not only do you receive what is effectively free money via tax relief, as well as tax-free growth, but you also benefit from the marvel of compound interest over many years. The result is that your savings grow like a snowball – the bigger they become, the faster they increase in size.

Both you, the government and your employer (if it’s a workplace pension) pay into your pot over many years, but thanks to compound interest you will end up with far more money even than this. And now, thanks to pension freedom, you have many more options as how you draw an income from it. With the traditional annuity no longer the only realistic choice, many more people are considering the drawdown option.

Drawdown involves leaving the pension pot invested in appropriate funds, where it can continue to generate growth. You can then draw income directly from the fund, using it more or less like an instant-access savings account. You choose how much or how little you withdraw each year, making it a more flexible option than an annuity.

It sounds simple enough. So what’s the problem?

The snowball effect

The core problem is the size of the pension pot you would need to generate sufficient income. In today’s market a drawdown fund (typically a portfolio of equities and bonds) should yield a growth rate of between three and four per cent – much more than that is unlikely. So if you want a modest annual income of £10,000 and hope to live off the growth alone, you would need a pension pot of around £250,000. Even then, you may have to reduce your income in years of poor growth.

The majority of pensioners won’t have anywhere near as much money to play with. To make the sums simple, let’s suppose a (still generous) pension pot of £100,000. Assuming the same four per cent growth, you could withdraw £4,000 each year and leave the capital sum untouched. But if you want your full £10,000 then you’ll have to take out another £6,000 each year. This eats into the capital sum, and so reduces the growth you make upon it. Over four years it would look like this:

Withdrawn Growth (at 4 per cent) Remaining capital sum
£10,000 £4,000 £94,000
£10,000 £3,760 £87,760
£10,000 £3,510 £81,279
£10,000 £3,251 £74,531

You can see that not only is the capital sum shrinking, but also that the growth is falling too, and that both are falling by more each year. Now the magic of compound interest comes back to bite you: the more you withdraw, the less growth there is, so the pot shrinks faster and faster. The snowball begins to melt.

An age old problem

Well, fine, you may say. Why else would I save up money except to spend it? A fair point – your goal is not to try and preserve your pension pot indefinitely, unless you want to bequeath it to your beneficiaries (now possible under pension freedom). But you do face a delicate balancing act between how long your savings will last, and how long you can expect to live. If your approach is too cautious, you may live an unnecessarily frugal retirement until you die with money unspent. But live too extravagantly and your savings will melt away, leaving you to survive on your state pension.

This is why drawdown is such a tricky arrangement to get right. It only looks like a simple savings account until you factor in the unknown element of your life expectancy. Ironically, this is the same conundrum that annuity providers have wrestled with for years: how to calculate the right level of annual income from retirement age until death. By choosing drawdown, you take on that puzzle yourself. You might stand a better chance of giving yourself a fairer deal – but if you misjudge, it could be you who faces financial meltdown.

If you’re interested in exploring drawdown or any of the alternative ways of taking a pension, a good way to start is with a free pension check. Find a participating adviser here and enjoy a £50 discount on any subsequent advice.