Pension drawdown: is it right for you?
Traditionally, when you reached retirement you would get a tax-free lump sum and the balance would buy an annuity (a guaranteed income for life).
Following the introduction of pension freedoms, there’s no need to buy an annuity. You can cash in the whole plan, with 25% being tax free, and the balance is treated as a single income payment and taxed accordingly – known as an ‘uncrystallised fund pension lump sum’ (UFPLS).
Or, you can take your tax-free cash and spread the balance over time, known as ‘pension drawdown’.
What is pension drawdown and is it worth considering?
The problem with the UFPLS is that you can pay a heavy tax penalty for getting all your money out, as the taxable part is added to any other income in the same tax year and could easily take you into higher rate tax.
Also, if you don’t really need the money, for example to clear off expensive debt, you would lose out on the tax-free growth that applies to pension funds.
An annuity provides a guaranteed income for life but annuity rates have plummeted in recent years. If you don’t have to buy an annuity straight away, you could adopt pension drawdown to start with and switch to annuities later in retirement.
Alternatively, you could secure part of your pension at the outset through an annuity and adopt drawdown for the balance.
Annuity rates are better at older ages, simply because you won’t live as long, especially if your health has declined. Most people qualify for medically enhanced rates by the time they are in their seventies. So buying now could be an expensive option.
Pension drawdown, also known as ‘flexi-access drawdown’, allows you take to your tax free lump sum, keep the balance invested in funds and draw down a monthly income that can vary to suit your changing needs from year to year. You can even take your tax-free cash in instalments alongside income withdrawals, which might help keep you below a higher tax bracket. There is, of course, a risk that the value of your drawdown fund could fall and that you eventually run out of money.
How to choose a drawdown plan and what to watch for
A drawdown plan should consist of a tailored ‘multi-fund’ investment strategy. This is quite different to a ‘multi-asset’ fund. While both spread the investment risk over a range of assets classes, the key difference is that the ‘multi-fund’ approach helps avoid what is known as ‘sequencing risk’. That’s the risk that you are drawing down from a depleted fund caused by a fall in the fund unit price. By splitting out the asset classes into different funds, some units will be going up while others are falling. A well-managed strategy exploits the contra-cyclical nature of different asset classes to mitigate sequencing risk.
In our experience drawdown has become the new ‘norm’ for most people with pension funds over £100,000. Annuities will still be important in the future, it’s no longer whether … but when?
Steve Patterson is managing director of Intelligent Pensions