Pension drawdown has become a highly popular option for those with a private pension. Thanks to pension freedom, this means that you have the option to withdraw money from your pension fund after the age of 55. The amount of retirement income, and how often, is up to you. There are some great advantages to this – the tax-free lump sum cash option is particularly popular – but this needs careful planning to avoid your money running out and a drawdown disaster.
What can go wrong with Pension Drawdown?
Many people are taking money out of their pension pot early, without thinking of the consequences in later life. Retirement is a big milestone and potentially a great opportunity to use the money you have saved in your pension fund to treat yourself – for example, a world cruise, or renovating the house. However, taking too much money out can lead to big problems later on.
The worst case scenario is, of course, the money running out. Remember, although spending tends to go down during retirement, you may face extra costs in later life due to health or care requirements. It is also possible for your investment to perform poorly, for example, if there are fluctuations in the market. If you withdraw too much, this means your investment is less able to recover in the long term.
How to avoid it
Income drawdown is not something you can decide on and then forget about. First, you need to plan your withdrawals carefully so you don’t pay too much income tax. You also need to plan how you are going to invest the rest of your pension pot. This is crucial: the way your investments perform affects how your pension fund grows. There is a range of options, with varying degrees of risk, and a financial adviser such as the team at Pension Works can deliver financial advice to help you choose a portfolio that’s right for you.
Another strategy could be changing the way of withdrawing from your pension. You may have set up a system where you withdraw a regular fixed sum – the same amount every month. You can change this to a fixed percentage. Although this means your income will vary, it means your withdrawals will adapt to how well your investment is performing and reduces the risk of your pension savings running out. Traditionally, many have recommended the 4% rule – you should withdraw no more than 4% of your total pension pot a year. This, however, is really a maximum, and many recommend a lower percentage – the Financial Times now cites 3.5% as the maximum1.
You can also choose where this income comes from. Taking ‘natural’ income means only withdrawing the money that’s generated by your investments. The investments themselves are untouched, and so they are more likely to recover from any market falls and you are less likely to run out of money.
The final option is to consider buying an annuity. Although you will need to check the fees and consult with a financial adviser to get a good deal, an annuity does allow a guaranteed income. You can put some or all of your pension fund into an annuity. Some defined contribution pensions allow you to combine income drawdown with an annuity.