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.
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 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.
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….
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.