Following UK pension rule changes implemented in April 2015 pension drawdown has become a lot more prevalent. It is expected that these amendments will affect how people withdraw income from their pension henceforth in the British market. Certain overseas QROPS markets are already in the process of altering their pension regulations to benefit from the increased flexibility offered by the new rules with more expected to follow in time. Although pension drawdown was more prevalent in the QROPS market beforehand, the seismic shift in pension policy by HMRC & the UK government in 2015 is likely to only increase its popularity.

Background

Previously, at least part of one’s pension had to be in the form of an annuity or the equivalent. Prior to 2011 drawdown was only available up until one reached 75 years old. After this age it was compulsory that pension funds were converted into a form of annuity. From the 6th of April 2011 this compulsory annuitisation ended, though only if one could show a secured annual income of £20,000 from a combination of state pension, defined benefit pension plans (most commonly known as final salary schemes) and/or existing annuities. Now, however, it is possible to only draw funds from one’s pension as and when required.

What is pension drawdown

Pension drawdown, also known as income drawdown or decumulation, is the process of withdrawing income from one’s pension pot to fund a lifestyle in retirement. The actual specifics may vary, for example one may decide to only withdraw income which is naturally generated from investments (e.g. dividends), sell investments, or a combination of the two, but the end result is the same.

Retirement options

Retirement is the period of life when one has no intention of working again in the future. It is therefore preferable that there is sufficient income being generated to maintain one’s lifestyle rather than relying on inferior provisions that will have an adverse effect on it.

There are only three main sources of income in retirement: state provisions, annuities, or investments. The former is a base minimum supplemented by the latter two, of which annuities are the less risky option. When one uses investments to provide income, usually via a pension wrapper, this is known as drawdown.
Graph depicting where income is generate. In retirement there are only 3 options: state provisions, investments or annuities

This will comprise of a basic state pension along with any credits or entitlements. The latter tends to be provided when there is deemed to be insufficient income to live on. Most government sourced state pensions only provide enough income to facilitate a very meagre lifestyle.
This is the least risky option for retirement since it provides a form of guaranteed ongoing income for the duration of one’s retirement. There are differing variants with some offering less protection, for example a fixed annuity, than others. It is therefore important for one to be fully aware of the benefits and drawbacks of any annuity that is considered.
This can take on a huge variety of forms and degrees of risk. The key difference between state provisions, annuities, and investments is that the latter offers no guarantee that it will last throughout one’s retirement irrespective of the form it takes because, at some point, there may be a need to withdraw capital instead of solely income. If the original assets purchased, the capital, does not provide sufficient income to live off of then part or all of the original asset will have to be sold. This could be for many reasons including dividends paid by shares or coupon payments by bonds being reduced, or there may be voids in rental agreements. In these circumstances, the sale of part/all of the capital reduces any future income leading to a vicious spiral. In reality, most retirement plans will have some form of decumulation phase where one’s assets shrink rather than grow. Though, in the same way that risk can be reduced when saving for retirement, the accumulation phase, similar principles can be applied through drawdown.


Making pension drawdown work

Firstly, it is important to realise that there is no universally correct rule for withdrawing income in retirement. In an ideal scenario one, or both in the case of a couple, would receive the maximum income throughout their retirement when they want it so that on the day of their/ the last person’s death they would have exactly nothing (or whatever amount they wished to leave to their dependants). Obviously, for this to happen in real life it would be complete luck because none of us can determine when we will die or know the exact returns all of our investments will provide over time. What is in our control, however, is the ability to reduce the risk inherent in pension drawdown.


Risks associated with the decumulation phase and how to avoid them

There are three main risks: running out of money: living on a reduced income in the future; and curtailing spending unnecessarily from the outset. All of these are linked and can be avoided by establishing a prudent withdrawal rate which is relatively straight forward to calculate….
 
Desired annual income less existing regular provisions = shortfall. Shortfall divided by remaining pension pot = y%. Scale 0-8% for y. Closer to 0 is lower risk. Closer to 8 is higher risk
 
To explain the above infographic. Once one knows the level of annual income they require in retirement any existing provisions that provide a known regular income should be subtracted. This leaves the level of income one hopes to have provided from their remaining investments. Establishing the likelihood of this occurring involves simply dividing the former by the latter. Anything under about 3% should be easily achievable. Anything over about 6% is increasingly unlikely to occur with the appropriate degree of risk associated with it.

Aiming for a conversion rate in the region of 5% or below, either by accumulating a greater investment pot for retirement whilst working or reducing one’s retirement income expectations, should prevent the risks associated with the decumulation phase assuming one’s investment portfolio is wisely invested.


Tips to invest wisely in pension drawdown

Assuming one’s investments for retirement generates sufficient inflation adjusted income then this should avoid the risk of one’s pension pot running out. In reality, this is unlikely since a degree of capital withdrawal is usually chosen. This route is normally only viable when a person’s investments are substantially larger than that required to fund their most lavish lifestyle.
In the same manner that investing regularly creates a phenomenon, known as pound cost averaging, which reduces the risk of investing regularly the opposite effect is a threat to one’s wealth during pension drawdown. Pound cost ravaging, which occurs during market falls, can be offset to a degree by timing withdrawals to create a buffer. Timing the market on the whole is unreasonable but, similar to knowing your target during the accumulation phase of investing can improve returns, selling additional investments whilst markets are buoyant can provide a buffer when markets fall. The buffer can then be used to prevent forced selling during the worst of any market drops though the level of reserves held in the buffer has to be carefully considered. Too little and one won’t be sufficiently protected by market falls whilst too big and it creates a high drag to the overall investment portfolio returns.
One should always be aware of the level of risk whilst investing. The process of switching from the accumulation to the decumulation phase of investing increases the risk associated with volatility all else being equal. This is because the benefits of pound cost averaging available whilst building up a pension pot will become drawbacks via pound cost ravaging. It is therefore important to re-assess one’s attitude to risk and alter one’s investments accordingly prior to retiring.
Investing successfully is a combination of art and science. No one has a crystal ball to predict the future. As it has been shown that pension drawdown is riskier than investing for retirement it is extremely important to be fully informed on the vagaries involved with investing in general, including how techniques such as diversification can reduce one’s risk along with why investments can become riskier depending upon the financial climate. One can also improve investment returns by simply ensuring they are invested in the correct way to ensure tax liabilities are minimised.

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How to make pension drawdown work written by Don MacRitchie average rating 5/5 - 4 user ratings