Pension drawdown has been available since 1995 but historically it was only thought suitable for those with funds above a certain size for instance above £ 100,000. With the new freedoms drawdown has become more popular and almost any size of pension pot should be able to benefit from drawdown. However, some pension companies may have minimum funds sizes for their drawdown policies.
Some of the customer friendly sections of this guide have been taken from my highly-acclaimed customer guide “You and Your Pension Pot” (sponsored by Prudential) and some of the more technical sections have been taken from my adviser guides. You can see a full list of my publications in the library.
What is pension drawdown
This a special type of pension plan which you can transfer to after the age of 55 and after taking your 25% tax free cash you can take income payments (which are taxed at your marginal rate) direct from your pension pot.
Your pension pot can be invested in a number of ways ranging from cash, bonds, equities and even property (you cannot invest directly in residential property).
After your death, any money remaining in your pension pot can be left to your beneficiaries.
In many ways, this is similar to taking an income direct from your bank or savings account (with some extra rules) and if you take more income than the interest or investment growth the value of your pension pot will reduce and at the extreme you could run the pot dry.
The most important thing to remember is that unlike an annuity, your income is not guaranteed and if you take too much income in the early years or if the fund does not increase in value as planned, you could end up with a lower income or even run out of money entirely. The graphics below show how drawdown may play out over the course of your retirement depending on investment returns.
If your pension fund increases in value after taking income drawdown payments you can increase your payments in the future.
If your pension fund decreases in value after taking income drawdown payments you may have to reduce your income payments.
Advantages and disadvantages
The technical stuff
All new pension drawdown plans are set up ‘flexi-access drawdown’ rules where there are no income limits.
Before 6 April 2015, drawdown plans were set up under ‘capped drawdown rules’ which restricted the maximum income to 150% of the GAD income factor. There may be some technical reasons why individuals may wish to continue with capped drawdown. For example, providing the 150% of GAD income is not exceeded, capped drawdown investors are not subject to the new Money Purchase Annual Allowance (see below).
The relevant rules for drawdown can be summarised under hour headings: income, investments, death benefits and pension limits.
There are no minimum or maximum income limits which means that up to 100% of the fund can be taken as an income payment and income payments can normally be taken at any time.
In practice, most people will either make regular income withdrawals to provide retirement income or a take series of ad hoc income payments to supplement their other retirement income in a tax efficient manner.
When regular income payments are taken, it is important to consider the ‘sustainable level’ of income (see below) and when ad-hoc payments are made it is especially important to be aware of the tax consequences.
All income payments will be taxed at the recipient’s marginal rate of tax. Higher rate tax payers may be able to reduce their tax planning by spreading or phasing income payments if they will be basic rate tax payers in future years.
A drawdown pension plan can be invested in a wide range of things including:
- Cash accounts with banks and building societies
- Pension funds from insurance companies
- Unit trusts and onshore and offshore open ended investment companies (OEICs)
- Investment trusts
- Individual stocks and shares quoted on a recognised UK or overseas stock exchange Commercial property
Typically, a drawdown plan will be invested in some of the above investments in one of following ways:
- Through an insurance or investment company
- On a platform arranged through an adviser
- Self-select (no-advice)
- Self-invested personal pension (SIPP) through an adviser
Investing in drawdown is very different from investing before retirement and therefore it is advisable to take professional advice, not only on the initial investment strategy but in order to have regular financial reviews to make sure the plan is on target.
Most drawdown plans offer three options following the death of the plan holder:
- Pay the balance of the drawdown pot as a cash lump sum
- Arrange flexi-access drawdown for beneficiaries (no income needs to be taken)
- Purchase an annuity for selected beneficiaries, normally a spouse / partner
If the plan holder dies before age 75, all payments (cash or income) will be tax free, but if death occurs after age 75, any cash or income will be taxed at the marginal rate of tax payable by the beneficiary.
Technically there are three types of beneficiary; a dependant, a nominee and a successor. A dependant is a spouse, civil partner, child under the age of 23 or someone who was financially dependent on the plan holder. A nominee is anyone nominated by the member and a successor is anyone nominated by one of the beneficiaries. In short, almost anybody can be nominated to be a beneficiary of a pension pot.
Although many people may choose to nominate their spouse or partner as a beneficiary, it is possible to nominate children or other family members or friends as beneficiaries and so the pension fund can be handed from one generation to another.
There are two important limits:
The Lifetime Allowance is a limit on the amount of pension benefit (cash lump sum or income) that can be taken from a pension plan without triggering an extra tax charge.
The lifetime allowance was introduced at a level of £1.5 m in 2006. It then increased each year to 2010 up to a level of £1.8 m. Since 2010, then a number of pension reforms has resulted in the lifetime allowance being reduced and the current level in the 2016-17 tax year is £1m.
When benefits are taken, or the plan holder dies, a calculation known as a benefit crystallisation event (BCE) takes place. The amount of cash and income taken is tested against the lifetime allowance. If the amount taken is less than the lifetime allowance nothing happens but if the amount is above the lifetime allowance, additional tax is payable.
If there is money invested in a pension pot (including drawdown) at age 75, another benefit crystallisation event takes place.
- Annual allowance and Money Purchase Annual Allowance (MPAA)
The annual allowance is a limit to the total amount of contributions that can be paid to defined contribution pension schemes and the total amount of benefits that you can build up in defined benefit pension scheme each year, for tax relief purposes.
Normally by the time someone converts their pension pot into drawdown they will have stopped paying money into a pension pot but if they are still paying money into a pension plan, or a member of a final salary pension it is necessary to check if the money being paid in is with the allowance for tax relief.
The annual allowance is currently capped at £40,000 per annum. However, if income is taken from a flexi drawdown plan or the upper income limit is exceeded with capped drawdown the Money Purchase Annual Allowance (MPAA) applies and the annual allowance is reduced to £10,000. This will be further reduced to £ 4,000 per annum after April 2017 under current proposals.
Get a personal drawdwown example using my drawdown calculation
There is a lot to watch out for but by far the two most important things to keep an eagle eye on are the amount of income you take out and where your drawdown is invested.
These two things are intricately linked because of the sequence of return risks. Investing when you are taking income withdrawals is different to investing without taking income and this is because if the returns are low or negative in the early years you will erode your capital fast and it will be hard to recover from early losses.
When you take income from a flexi-access drawdown it will be a trigger event for the Money Purchase Annual Allowance (MPAA).
Although drawdown may seem easy to understand the risks are much harder to understand, especially if compared to the guaranteed income from an annuity.