Income drawdown gives you a variety of options during retirement and complete control over how you use your retirement savings. However, with this freedom comes responsibility. It’s up to you to manage your income so that it lasts for the whole of your retirement, which could be 30 years or more.
It’s important to be clear about how you intend to use drawdown and why you think it’s the best way to achieve your goals, compared with the alternatives. You also need to be self-disciplined, because if you’re reckless with the freedoms on offer then you could burn through your pension savings too quickly.
Here are the key principles you should observe before making any decisions:
Don’t go into drawdown without being certain it’s right for you
Income drawdown enables you to withdraw whatever you like, whenever you like, from your pension pot, while leaving the rest invested. It therefore makes a variety of retirement strategies possible, which each carry their own risks. For example, you could:
- Live off the withdrawals from your pension pot, while giving yourself the flexibility to spend more in some years – perhaps to fund big family events or dream holidays. The risk of this strategy is that, through a lack of self-discipline or poor investment performance, you could run out of money and end up dependent on the state.
- Cover your basic everyday expenses for life by using some of your pot to buy a lifetime annuity. This will give you a guaranteed income stream and leave you free to invest the rest of your pot or make withdrawals of any amount at any time. The risks here could include locking yourself into a lower annuity rate than you might have achieved by waiting, and/or seeing your pension pot shrink while it remains invested due to underperformance.
- Use drawdown initially then use another product to generate income. For example, you could start by living off withdrawals while leaving the rest of your pot invested. You could then use the remainder to buy a lifetime annuity, for example, if your circumstances have changed and you need the security of a guaranteed income, or because annuity rates have improved. Again, there can be no guarantees.
These are just some of the many possibilities under the new pension rules. If you’re considering using a drawdown product then it is really worth seeking guidance or advice from a professional. You can go it alone if you wish but you may risk missing out on opportunities to make more of your retirement savings.
The government’s new Pension Wise service is a good place to start – their guidance specialists will give you a free consultation to help you understand your options: over the phone, online or face-to-face at a Citizens Advice Bureau.
For a more detailed look at your finances you’ll need to consult a financial adviser who is regulated by the Financial Conduct Authority (FCA). They’ll be able to make specific recommendations based on your circumstances, needs and goals. If you don’t have a financial adviser but are interested in finding one you can use our free online search tool.
Finally, don’t be afraid to ignore the new pension freedoms if they don’t suit your needs. Your retirement savings must provide an income for the rest of your life, so if you’re not sure you can cover your essential outgoings for the next 30 years then a drawdown product probably won’t fit the bill. The traditional route of taking a tax-free lump sum upon retirement and then using the rest of your pot to buy a lifetime annuity may be a better option.
Don’t ignore the risks of staying invested
Any money you put into a drawdown product remains invested until you withdraw it. It will therefore continue to receive the same tax benefits as other pension investments –attracting no capital gains tax, for example. But it will also face the same risks, and its value could fall as well as rise. You therefore need to consider what might happen to your retirement income in the worst-case scenario.
By entering drawdown you’ll need to manage a portfolio of investments or get someone to do this for you. This will involve checking the performance of your investments regularly – at least once a year – and adjusting your holdings to give you the best chance of getting the returns you require. If your investments don’t perform as expected, this could prevent you from withdrawing as much as you’d intended.
If you don’t have a lifetime annuity in place to cover your essential outgoings, and your investment returns fail to deliver, you could begin to run out of money faster than anticipated. You may even end up drawing less money overall from your pension than if you had used your entire pot to buy a lifetime annuity on the day you retired.
Don’t fail to factor in your future living costs
We’re living for longer, and we’re remaining more active in our old age. If you’re in your mid-fifties then you need to consider the possibility that your retirement will last for 30 years or more. Any money you have saved for retirement therefore needs to stretch a long way, whether it’s held in a pension, an investment account or other assets.
If you transfer some or all of your pension pot into an income drawdown product then you’ll be able to withdraw however much you like, whenever you like. But you’ll also be responsible for making sure that you don’t run out of money too soon. So it’s vital that you consider in advance what the effect of drawing out particular sums would be over certain periods of time. Clearly, you need to ensure you can cover your essential outgoings as well as setting aside money for more specific retirement goals such as travelling the world or leaving a legacy for future generations.
Don’t overspend today, and regret tomorrow
From 6 April 2015, you’ll have the ability to withdraw up to 100% of your defined contribution pension pot as a single lump sum. But you can only withdraw 25% of it tax free, with the remainder being taxed as income. So, if you start your retirement by making a very expensive purchase you could put yourself under pressure in two ways:
- You could deplete your pension pot so much that you end up running out of money during your retirement and have to rely on the State Pension.
- You could pay a significant amount of tax, which you might not have to pay if you spread your withdrawals out over a longer period.
Although it may be tempting to go on a spending spree with your own money, the flexibility of income drawdown is not a reason to do so. Instead, it may be best used as a method of adding flexibility to your retirement income stream for specific purposes – for example, to cover big expenses you expect to face during retirement or to help deal with unexpected emergencies. Remember: your pension pot has to last for the rest of your retirement, assuming you have no other sources of income.
A final point to consider is that if you withdraw more than you need from your pension pot using income drawdown then you will end up having to find a home for that money while it remains unused. In this situation, you may find it difficult to generate the same return on that money as you would have received by leaving it untouched.
Don’t get fined by HM Revenue & Customs
If you start to use a flexi-access drawdown product after 6 April 2015 and it’s not your only pension, you’ll have to notify all the providers of your other pensions within 91 days or face a fine from HM Revenue & Customs (HMRC).
The reason for this is that HMRC doesn’t want people abusing the new system by ‘recycling’ their pension funds – taking the tax-free portions of the lump sums they withdraw and pumping them into other pensions in order to save more tax further down the line.
Once you start using a flexi-access drawdown product, you’ll therefore have your pension contributions allowance – the amount you can pay into a pension each year with tax-relief – reduced from £40,000 to £10,000 for defined contribution schemes.
Failure to meet the 91-day deadline could lead to a £300 fine, with further fines possible if the situation isn’t resolved. Before you take any income from your pension savings, you may consider consolidating all of your pensions into a single product that allows flexi-access drawdown, and that has all the other features you require to build your preferred retirement strategy.