A guide to pension drawdown

10 March 2018

The private pension investment landscape changed fundamentally with the introduction of Pension Freedoms.

Significantly, the range of options available to anyone 55 years or older has widely increased, regarding how they choose to use the savings in their pension pot - or indeed pots. 

As always, the freedoms allow income drawdown pension pot holders to take a quarter (25 per cent) of their pension savings as a tax-free lump sum, but there is no longer a legal requirement to use the rest to buy an annuity.

Now savers can take the 25 per cent tax free sum and also take the rest out immediately, taxed at their working income tax rate.

It is very important to take on board at this stage that these freedoms only relate to private pensions, not to the State Pension, and, specifically, only to defined contribution (DC), or 'money purchase' pensions; not to defined benefit (DB), or 'final salary' pensions.

The Freedoms

Given the responsibility of managing a private pension has been well and truly handed over to the pension pot holder, it should also be recognised that indeed, so have varying degrees of risk in relation to how each option operates.

Firstly, savers should avoid so-called pension liberators, (perhaps making contact through cold calls), who claim they can help you access your pot before you reach 55 years old.

This is untrue! They’re scammers! Avoid them!

One immediate question often asked in light of these freedoms is, ‘should I take out my pot as soon as I can?’. The answer to this is generally ‘no’ - (of course, particular personal circumstances may dictate otherwise - seek advice!): If you’re working towards retirement and still in your 50s or 60s, - the aim should be to put yourself in an even better position to have enough income when you do retire. Keeping your money in your pension pot will hopefully enable it to grow even further. However, it’s very important to continually monitor the performance of your pension/s, and how your money is being invested and managed - a monthly online check should be enough.

There are 6 ways you can manage your DC pension pot:

1. Leave your pension pot untouched

You don’t have to start taking money from your pension pot/s, when you reach your selected retirement age (the age you agreed with your provider to retire); you may leave your money invested in your pot/s until you need it.

Tax Implications:

You don’t pay tax while the money stays in your pot. Money you leave in your pot can be passed on tax free if you die before the age of 75.

Fees and investment risk:

You may be charged extra fees if you don’t start taking your money when you reach your selected retirement age - check with your provider and remember that the value of your pot could go up or down.

Continuing to pay in:

You (and your employer) can continue to pay into your pot, but there may be restrictions.

You usually pay tax if savings in your pension pots go above the annual allowance. This is currently £40,000 per year.

2. Guaranteed income (Annuity)

You choose to use your pot/s to buy an insurance policy that guarantees you an income for the rest of your life - no matter how long you live.

Specifically:

• You get a fixed income for life or for a set number of years
• You can take 25 per cent of your pot as tax-free cash and buy an annuity with the other 75 per cent.
• You pay tax on your annuity income.

*If you’re currently receiving a pension income it’s likely that you’ve already bought an annuity, or are taking an income from a final salary or career average (defined benefit) pension.

3. Adjustable income

You invest your pot to give you a regular income and decide how much to take out and when, as well as how long you want it to last - thereby making it adjustable.

So, you get 25 per cent of your pot as a single, tax-free cash sum; the other 75 per cent is invested to give you a regular, taxable income.

This option is known as ‘flexi-access drawdown’ and you will probably need to be involved in both choosing and managing your investments with your independent financial adviser (IFA). However, it’s important to note that all pension providers offer this option.

Also bear in mind that the value of your pot can go up and down.

Tax implications:

The income you get from the investment is taxable. Your provider will pay you the income with any tax due already taken off.

To answer the often posed question, you pay tax when you take money from your pot because, when you are paying into your pension, you get tax relief on your contributions.

Also bear in mind…

Your provider will offer you different investments with different risks; you then pick the right investments that will deliver a retirement income for you. You should also think about how much you take out every year and how long your money needs to last.

To make the best decision you can, create an investment plan for your money with the direct help of a financial advisor; they’ll be able to tell you how much money to take out at any one time to ensure it lasts for your lifetime - but of course, they will charge a fee.

Bear in mind also that your provider will also charge you a fee; importantly, if that provider goes bust you are covered by the Financial Services Compensation Scheme.

Continue to pay in:

A number of people have more than one pension pot; if this is the case you can take an adjustable income from one and continue to pay into others, however, you may have to pay tax on contributions over £4,000 a year (known as the ‘money purchase annual allowance’ (MPAA).

4. Take cash in chunks

You can take smaller sums of money from your pot until you run out and your 25 per cent tax-free amount isn’t paid on one lump sum - you will receive it over time.

Each time you take a chunk of money 25 per cent is tax free and the rest of the ‘chunk’ is taxable.

Bear in mind that some pension providers charge a fee to take cash out, while some don’t even offer this option; if your current provider doesn’t offer it you can transfer your pot to another provider, but you may also have to pay a fee to do this.

5. Take your whole pot in one go

You have the option to cash in all of your pot/s, which will mean 25 per cent of the total sum is taxable and the other 75 per cent will be taxed.

But, do bear in mind, taking a large sum of money out over a particular amount may leave you subject to paying even a higher rate of tax.

Your pension provider will take off the tax you owe before they pay you your cash; in addition, that cash will be added to any other income you make over the tax year, eg. money from work, savings or benefits.

You may also have to pay emergency tax when you take money from your pot, which you can claim back; your provider should pay your emergency tax back automatically, but if that isn’t the case you can claim it back from HM Revenue and Customs.

6. Mix your pension options

There is the choice to mix your options, which for the pension saver who likes to hedge their bets or diversify may seem the best road to go down. An example of mixing options is to use some of your pot to get an adjusted income and some to buy an annuity. If you have a number of pension pots you can also use different options for each pot, leaving one untouched, taking chunks of cash from the other, etc, just bear in mind that there may be additional tax consequences and always check with your IFA before taking any action with your provider.

Also, again, bear in mind that not all pension providers will offer the mixed option.

Download the full ‘What Investment’ guide to income drawdown here.

Think about the risks - avoid spending sprees!

It may seem obvious (or perhaps even patronising), but the adage ‘ keep calm and carry on’ should be at the forefront of anyone’s mind who has decided to take a large sum from their pension pot. The first act definitely shouldn’t be to pop out and buy that coveted Lamborghini, or take that six month cruise around the Caribbean (as tempting as it would be).

And, of course, there are the aforementioned scammers out there; beyond trying to convince people to take their cash ahead of their 55 year old birthday, (often illegal and unsurprisingly massively expensive), they urge people to take cash from their final salary pensions when they shouldn't - or promote a variety of other dubious schemes/scams.

Final salary pensions

**This editor would always advise final salary pension savers, who may be considering converting their pension pots into cash, to seek the advice of well established, independent, financial advisors.

Where's the help?

A number of people have assumed Government has provided a free advice service for DC private pension holders - it hasn’t.

What it has done is set-up a free guidance service called Pensionwise.

Importantly, the service will tell you what you can do, not what you should do.

It won't include help on your benefits, or on what product to get. However, you are able to book a Pensionwise telephone ‘guidance’ appointment on 0800 138 3944.

Therefore, if you have a significant pension pot/s, it is always worth spending approximately the £1,000 it'll cost to get an independent financial adviser (IFA) to actually tell you what to do (but do get quotes first from a few IFAs).

You can find a local IFA through VouchedFor or Unbiased. Meanwhile, there is a raft information out there on Independent Financial Advice.

Two other useful port-of-calls for information are The Pensions Advisory Service and the Money Advice Service.

The workplace pension

A workplace pension is arranged by your employer as a way of saving for your retirement; some workplace pensions are called ‘occupational’, ‘works’, ‘company’ or ‘work-based’ pensions.

A percentage of your pay is put into the pension scheme automatically every payday.

In the majority of cases you employer will also add money to your pension scheme and you may also get tax relief from the government.

By 2018 all employers must have a workplace pension scheme in place. This is called ‘automatic enrolment’; your employer must also make contributions to your pension if all the following apply:

• You’re classed as a ‘worker’
• You’re aged between 22 and State Pension age
• You earn at least £10,000 per year
• You usually work in the UK (detailed guidance on this)

Your employer may delay the date they enrol you in certain circumstances.

The State Pension

It’s important to decide when you take your State Pension once you reach State Pension age.

You can’t take your State pension early, but you can delay when you start receiving it - this is called deferring the State Pension.

Welfare benefits

Private pension savers in receipt of a means-tested benefit, such as Jobseeker's Allowance or Pension Credit, may find their benefit will be reduced once they start receiving a pension income.

If a saver receives a lump sum this may count towards your savings total, and if that person has over £6,000 of savings it can subsequently reduce their benefit; if a pension income amounts to £16,000 during a year benefits are likely to be stopped.

It should also be noted anyhow that, once someone reaches state pension age, ie, currently 66-67 for both men and women at the time of writing: 2 February 2018, (increasing from 67 to 68 between 2044 and 2046), that person may lose some benefits even if you don't take their pension because it counts as 'notional income'. For more help on pensions and benefits speak to Citizens Advice and use the 10-minute benefits checkup.

Some nuts & bolts about the options

Most people won’t want to opt for the ‘take all the money and run’ scenario, which means they will choose one of the more conventional options. These present as the option to either take out an annuity or choose another form of ‘drawdown’.

The problem with annuities

When you reach retirement, a lot of people just take the first annuity they are offered:

This could be a big mistake - you can often get a much better annuity rate by shopping around, especially if you have any health problems. (See ‘How Drawdown works’ below).

Annuities versus other income drawdown

Annuities give you a fixed, guaranteed income for life. However, there are a few problems with this.

To start with, although you might have a fixed income of, say, £10,000, that money won't be worth as much in ten, 20 or even 30 years' time as it is now. Inflation will eat away at it, and if you live a lot longer than you expect, you could really struggle to keep up with rising living costs.

You could buy an inflation-linked annuity, but you'll then have to accept a much lower income at the beginning of your retirement when you might want to spend more, for example on holidays.

A Drawdown

Drawdown is not a financial product; it's a set of rules about how you can take money from your pension.

In drawdown, you leave your money invested (in stocks, bonds, funds or whatever) and draw what you need – within certain limits that are set by the government.

Drawdown is not a one-way street. You can also choose to use your drawdown fund to buy an annuity later. However, once you have bought an annuity, the decision is irreversible.

How pension income drawdown works

It might help to imagine drawdown as a wrapper. You can shift as much of your pension as you like into that wrapper, still invested in shares, bonds or whatever. Once in, it cannot be moved back out again, though, as mentioned, it can be used to buy an annuity later.

You cannot withdraw money from your pension fund directly: drawdown or buying an annuity are the only two ways to get an income out.

The crucial rules

Most important are the rules about how much money you can withdraw. This amount is determined by the Government Actuary's Department (GAD) and is dependent on your age and the yield on a 15-year government bond at the time you enter drawdown.

There are also rules about what happens when you die. Money in drawdown is subject to 55 per cent tax before being passed to your heirs.

But do check with your pension provider, because some pension funds will also allow you to keep at least 50 per cent of your pension pot for your spouse or civil partner.

In contrast, untouched money in your pension will not attract death duties until you reach the age of 75 (when it does become subject to 55 per cent tax on your death).

But, if you do have an illness, which suggests sadly that you are likely to die prematurely, you may be able to access a higher rate of income for life; also, where a saver lives, their current age, fitness and whether they smoke, are all taken into consideration.

It’s also important to note, according to www.gov.uk, that you may be able to take your whole pension pot as a tax-free lump sum if all of the following apply to you:

• You’re expected to live less than a year because of serious illness
• You’re under 75
• You don’t have more than the lifetime allowance of £1 million in pension savings

If you’re over 75 you will pay Income Tax on the lump sum.

Meanwhile, generally for those in reasonable health, there is an Office of National Statistics (ONS) life expectancy calculator, which may prove useful and thought provoking.

Ingrid Smith is a UK based senior content strategist, storyteller & mentor