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How to make your retirement pot last with income drawdown

If you opt for income drawdown make sure you take money from your pension in a sustainable way
May 5, 2017

Income drawdown, also known as flexi-access drawdown, allows you to flexibly manage your retirement income to meet your individual circumstances. Using this option, from age 55 onwards you are able to take up to 25 per cent of your pension pot tax-free and use the rest to generate income.

But there are several risks to taking this approach rather than buying an annuity, which provides a guaranteed income for life, the most serious being that you run out of money in old age.

A number of factors could cause this to happen:

■ A major financial crisis during your retirement could reduce the value of and income from your investments.

■ Higher inflation might reduce the purchasing power of your portfolio and its income.

■ A long illness could force you and/or your spouse to go into a care home or have live-in carers, which can easily cost £50,000 a year.

■ You and/or your spouse may live longer than expected and end up using all of your pot.

■ You may unwittingly draw an income that is not sustainable over the long term.

"If you are in drawdown you are taking risks and so need to remember that the more you withdraw from your pension, the more likely it is that you will run out of money," says Patrick Connolly, certified financial planner at Chase de Vere. "In the past it was considered reasonable to take income of around 5 per cent a year and still be quite confident of protecting your capital. However, we are now in a low interest rate environment which looks set to continue for some time, so even withdrawals at 4 per cent a year could put your pension fund at risk - especially if your underlying investments perform badly."

So make sure you regularly review your income withdrawals and investment strategy. Mr Connolly adds that most people would benefit from having some guaranteed income from their state pension and/or defined-benefit schemes or lifetime annuities.

"Those who have secured income to cover their basic living costs are more able to take the risks of going into drawdown because, if the worst happens, they will still be able to pay their daily bills," he explains.

 

Consider your investment strategy

If you retire in good health in your mid 60s, it could be that your drawdown pension fund remains invested for two or three decades, or longer. So to beat the effects of inflation and generate a real return over this time you will need to hold some equities, as these offer the potential for strong long-term returns. But capital protection is also important, so it's a good idea to have more secure assets such as fixed income, which may also help with diversification.

Danny Cox, chartered financial planner at Hargreaves Lansdown, says most people would benefit from having a balanced investment portfolio. And moving your portfolio from riskier growth stocks and funds into more income-focused stocks and funds, as you reach retirement, could also be beneficial.

At present, an income portfolio can generate between about 3 per cent and 5.5 per cent a year, and also offer some capital growth, but typically the more income you receive the less capital growth you will get.

"An income of around 3.5 per cent to 4 per cent a year is the maximum you should be taking, and really you should be taking whatever the natural yield is - even if that's less," says Mr Cox. "If you don't draw more than 4 per cent or the natural yield, the probability is that your pension fund will be sustainable enough to keep you going through the upsides and the downsides. But if people draw 6 per cent a year, when the markets are doing well they'll be fine but if markets do badly they'll eat into capital. And that could have a very detrimental effect in the long term."

Holding at least 10 per cent of your retirement pot in cash is worthwhile as this gives you the ability to cover unexpected short-term income needs without depleting your capital. However, if you retire at, for example, 60 you could have a 30 year plus time horizon, so it is important to have a well-diversified portfolio across all asset classes including equities.

For this reason, Jonathan Drysch, chartered financial planner at Killik & Co, allocates to different assets to cover different periods of time in retirement.

"Equities provide inflationary protection, however the Financial Conduct Authority's stance is that investors shouldn't invest in equities if their capital will be sold or drawn upon within five years," he explains. "Therefore, advisers will often segment clients' self invested personal pensions (Sipps) into different time horizon periods - especially if capital is being drawn upon rather than just the income."

For example, to cover income in the first five years of retirement Mr Drysch looks to have an element of cash and non-equity income producing assets; to cover income in years five to 15 of retirement he would include growth and income equities; and to cover income from year 15 of retirement onwards, he would include more growth orientated investments.

He says: "Of course, the Sipp should be reviewed every year, and the equity exposure should possibly be decreased if capital is being drawn upon at a faster rate than initially expected."

Manage how you take income

It is important to think about the net amount you will receive from your pension pot when taking taxable income.

"If you're a higher-rate taxpayer, you're going to be paying 40 per cent on the taxable withdrawals, so if you're drawing 4 per cent from your Sipp, once you take off higher-rate income tax, that leaves you with 2.4 per cent," explains Mr Drysch.

So you should try to generate an income in the most tax-efficient way possible. For example, instead of taking out the 25 per cent tax-free lump sum in one go as soon as you retire, you could draw it out over a number of years.

Gary Smith, chartered financial planner at Tilney Financial Planning, explains: "Let's say you had a pension fund of £200,000 at age 60. If you took the full tax-free cash out you'd take £50,000 and the remaining £150,000 would remain invested. But if you didn't take the tax-free sum in one go, most of that £200,000 would remain invested for the next 20 to 30 years. Let's say it goes up in value to £300,000 by your 75th birthday, even though you've been taking some income from it. By drawing down in phases you would still be entitled to 25 per cent of that growth as tax-free cash. But if you had taken it all at outset, any subsequent growth would be subject to income tax."

Another way you can minimise your tax bill while drawing an income is by using your personal allowance - the amount you are able to earn before paying tax. For the 2017-18 tax year this is £11,500 per person.

If you have no other source of income, you can withdraw £11,500 from your pension as income without paying any tax. Your pension provider will still apply tax to this amount, but you will be able to claim it back from HM Revenue & Customs.

"On top of that you're still entitled to tax-free cash on the segment you've withdrawn from your pot so that would be a total of £15,333 you can take out of the pension tax-free," Mr Smith adds.

So a married couple could generate a tax-free income of £30,666 a year, or £2,555 a month if they both do this.

If you are receiving other forms of income such as the state pension, and it doesn't use up all of your annual personal allowance, you could use any unused personal allowance to withdraw additional income from a pension pot. For example, if you had £6,000 of unused personal allowance, then using this and part of your tax-free lump sum entitlement, you could take £8,000 from your pension without incurring tax.

Also bear in mind that your income requirements are likely to change during your retirement. In early retirement, when you remain in good health, your spending may increase as you travel and enjoy yourself, but this could dip in your 70s or 80s when you become less active, before rising again as your health starts to deteriorate.

"You may be willing to suffer some capital erosion in the early part of your retirement if you are prepared to take a reduction in income in later years," explains Mr Smith.

 

Make use of other assets

If you have assets other than your pension you could make use of other tax allowances to generate a tax-efficient income. For instance, any dividends you receive from investments held outside a tax wrapper benefit from the tax-free dividend allowance, which this tax year is £5,000. You could also make use of tax wrappers such as Individual Savings Accounts (Isas) as the income, profits and proceeds from investments held within these are free of income, dividend and capital gains taxes. This tax year you are able to save £20,000 into Isas. But unlike pensions, Isas are subject to inheritance tax (IHT) at 40 per cent.

Mr Cox says: "Death taxes are important, and as your pension fund can be passed on completely tax-free if you die before age 75 [or, at the beneficiaries' income tax rate if you die after 75] there's a good argument for drawing on your Isas or other assets first because they will incur IHT, whereas pensions won't be."

This is another reason not to take the tax-free lump sum in one go. Mr Smith says: "If you took your 25 per cent tax-free cash at once and put it in the bank, all you've done is brought that lump sum into potentially being part of your estate for IHT, whereas if you leave it in your pension to grow and take it out as and when you need it to spend, you're avoiding the potential for IHT to be levied in the future."