Pension Drawdown: 6 Essential Tips

Pension drawdown has increased in popularity since the introduction of Pension Freedoms in 2015. While buying an annuity used to be the default option, more retirees are now seeking the flexibility of drawdown.

Opting for drawdown allows you to withdraw as much as you like from your pension, providing you are over the minimum pension age (currently 55, although expected to rise to 57 in April 2028).

Of course, just because you can doesn’t mean you should. A sensible drawdown plan can help to ensure that you don’t outlive your fund or pay more tax than you need to.

1.      Use Other Assets First

Pensions are one of the most tax-efficient investments you can hold. As such, it makes sense to keep them for as long as possible. Pensions currently grow free of tax and remain outside your estate for IHT purposes. However, tax treatment rules may change in the future.

If you die before age 75, your pension can be passed on to your loved ones without the deduction of any income tax. After age 75, your beneficiaries can withdraw money from your pension as they see fit, taxed at their marginal rate.

While everyone’s circumstances are different, it is usually efficient to draw on your assets in the following order:

• Cash
• Taxable investment accounts (subject to tax limits)
• Investment bonds (subject to tax limits)
• ISAs
• Pensions

This means that investments with preferential tax treatment (and higher growth potential) are held for longer, improving returns over the course of your retirement.

So, the first tip regarding your drawdown fund is to consider whether you need to access it.

2.      Keep Enough Cash

Even when you are retired, it’s important to keep an easily accessible cash reserve to cover any emergencies. While redundancy is no longer a concern, urgent repairs or periods of ill health could still result in the need to access cash quickly.

You should also consider any planned spending over the next year or two. It’s worth keeping enough cash aside to cover this rather than relying on your pension or investments for ad hoc withdrawals.

Dipping into investments early can reduce the growth potential of your funds. If the market falls and you withdraw money, it will be more difficult for the remaining fund to recoup its losses. Keeping a cash reserve means you can remain invested through the peaks and troughs, which should ultimately improve returns.

If you are drawing a regular income from your pension, keep a sufficient cash reserve within the fund. The amount will depend on your needs, typically between one and five years’ worth of spending. Again, this avoids the need to draw on investments early or during a market downturn.

3.      Invest Sensibly

When you opt for drawdown, this means keeping your funds invested, with the associated risks, well into your retirement.

You may need to consider taking some risks to help ensure your pension keeps pace with inflation. However, you may also find that your risk appetite and tolerance reduce as you get older, and you might become less comfortable with market fluctuations. This is particularly true if you are relying on your pension fund to cover your expenditure.

When investing your pension fund for retirement:

• Avoid placing too much in high-risk or complex investments.
• Consider a wider range of assets. This should include some equities. While these can be volatile, they also help to provide the best chance of protecting your fund against inflation.
• Consider assets that produce a natural income.
• Aim to keep costs under control.

Of course, if you don’t need access to your pension fund immediately or plan to pass it on to the next generation, you can probably afford to take a bit more risk.

A financial adviser can help you to create an investment strategy for your pension.

4.      Avoid Unnecessary Tax

When you take benefits from your pension, the first 25% will be tax-free. Older occupational pensions may even have a higher entitlement. Anything you withdraw over that amount will be taxed at your marginal rate.

You can choose to take tax-free cash (subject to the 25% limit), taxable income, or a combination of both.

The appeal of drawdown is that you can vary your income according to your needs. For example:

• Drawing tax-free cash in years that you have other taxable income.
• Taking taxable withdrawals to use up your personal tax-free allowance if you don’t have any other income.
• Reducing your taxable withdrawals when your income increases, for example, when the State Pension comes into payment.
• Using other sources of capital for large withdrawals. Taking a taxable lump sum from your pension could push you into a higher tax band.
• Avoid taking taxable pension withdrawals while you are still working. Not only will this increase your tax bill, but you will also trigger the Money Purchase Annual Allowance (MPAA). This limits your future pension contributions to £10,000 per year, with no option to carry forward contributions from earlier years.

A comprehensive retirement plan can help to reduce tax by optimising income from different sources.

5.      Use Realistic Assumptions

The objective of any retirement plan is to ensure that your money outlasts you. While nothing is guaranteed, the following can improve the likelihood:

• Be optimistic about life expectancy. While UK life expectancy is around 79 for men and 83 for women, those who remain in good health in their 50s or 60s may exceed these averages.
• Consider how your spending could change over your retirement. Most people spend more time in their early years as they travel and take up new hobbies. This usually reduces in the later years, although it can increase substantially if care costs are required.
• Remember to take inflation into account. You might not increase your spending every year, but if you assume you will, you could have more flexibility if prices go up.
• Use conservative assumptions for investment growth, and remember that this is an average over time, not what you should expect every year.

The goal of assumptions is not to predict the future, but to provide a sensible starting point which can be adjusted as time moves on.

6.      Keep Your Plans Under Review

There are several moving parts to consider within your drawdown plan. Your requirements could change, or investments may not perform as expected.

By arranging regular reviews, you can ensure that your investment strategy is suitable, that your assumptions are appropriate, and that you don’t pay too much tax, even as your circumstances evolve.

Please don’t hesitate to contact a member of the team to find out more about your retirement options.

The value of investments can fall as well as rise and is not guaranteed.