Pension Drawdown: 6 Essential Tips

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 rising to remain 10 years under the prevailing State Pension age).

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. Not only do pensions grow free of tax, but they are also outside your estate for Inheritance Tax purposes. If you die before age 75, your pension can be passed on to your loved ones without the deduction of any 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 at all.

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 taking a regular income from your pension, you should also keep enough cash within the fund. The amount will depend on your situation, but could be anything from one to five years’ worth of spending requirements. 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 will need to take some degree of risk to ensure that your pension holds its value alongside inflation. But 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.
• Invest in a wide range of assets. This should include some equities. While these can be volatile, they also 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 if you 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.
• Avoiding taking taxable pension withdrawals while you are still working. Not only will this increase your tax bill, but you would also trigger the Money Purchase Annual Allowance (MPAA). This limits your future pension contributions to £4,000 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 the typical life expectancy for your area may be 85, if you have reached your 50s or 60s without any major health problems, there is a good chance you will live for many years longer than average.
• Consider how your spending could change over your retirement. Most people spend more in the early years as they travel and take up new hobbies. This usually reduces in the later years, although 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 will 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.