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Home > Blog > Pensions > Understanding The Risks Of Pension Drawdowns
Pension drawdown or flexi-access drawdown is a convenient way to take an income in retirement that gives you flexibility over how much and how regularly you take funds from your pension. You can take lump sums or a regular income whilst the rest remains invested, enabling you to dip in and out of your funds as and when you need to.
The major benefit of pension drawdowns is that added flexibility compared to a Pension Annuity. Your pension funds also have the potential to grow whilst they remain invested. However, the converse to that is that they may also depreciate in value at the hands of market fluctuations. Therefore, your income is not guaranteed and you could run out of money without careful planning.
This is where we come in.
Hilltop Financial Planning has a dedicated team of retirement planning experts who are here to help you get the most out of your hard-earned pension savings. Keep reading to find out more about retirement income risks associated with pension drawdowns and how sustainable withdrawal rates can help you to avoid total pension fund depletion.
Pension drawdown is a flexible pension withdrawal option available to most pension holders. Since April 2015, all new pension drawdown arrangements are what is known as ‘flexi-access drawdown’ products. These enable you to take a 25% tax-free Pension Commencement Lump Sum (PCLS) and withdraw the remainder either by taking a regular income or ad hoc lump sums as and when required.
Some schemes prior to that date enabled pension holders to opt for a so-called ‘capped drawdown’, which lets you take a tax-free lump sum, invest the remainder with a crystallised pension, and take a limited or ‘capped’ income. Capped drawdown is no longer available for new arrangements. If you have previously elected for this option, you can either opt to retain it or convert to a flexi-access scheme – depending on your provider’s terms and conditions.
Pension drawdowns offer several advantages over other retirement income options (such as annuities), including:
There are various risks associated with pension drawdowns that your retirement planning should bear in mind, including:
It is worth noting that any income you take from your pension above the initial 25% is taxed similarly to income earnings. Therefore, Pay As You Earn (PAYE) tax is deducted from your pension income before it is paid to you. However, the major benefit of using pension drawdowns is that you can control the amount and frequency of your withdrawals.
With that in mind, you can minimise your tax burden by keeping your withdrawals within the personal allowance or a 20% basic tax rate wherever possible.
Longevity risk is the very real possibility of outliving your pension funds and any other investments or capital. Although life expectancy in the UK lags behind most other G7 countries, many pensioners still underestimate their life expectancy. Research by Vitality found that if a retiree on an annual drawdown income of £13,862 lived five years longer than they had envisaged, they would be left with a pension shortfall of £50,000.
Therefore, it is important not to live beyond your means – particularly in your early retirement years.
Typically, low inflation enables a pension fund to grow at a faster rate than inflation over time. However, high inflation rates will generally stall the growth of a pension fund, eroding the value of the pension pot. This is perfectly normal, and all long-term investments are subject to fluctuations over the course of their lifetime.
To mitigate periods of high inflation and rising living costs, as we are currently experiencing, one option is to diversify investments across cash, stocks and bonds. This approach can spread the risk and provide security over the short, mid and long term. Another option is to pause your pension drawdowns and take income from tax-free investments, like ISAs, until inflation stabilises once more. Before making any decisions or changes to your pension or income strategy, it is always wise to speak with a fully trained financial professional.
A sequence of returns risk or sequence risk is the threat of your pension savings being exposed to the poorest returns at the most inopportune time. That threat is at its greatest as you transition from the accumulation phase in employment to the decumulation phase of drawing an income from your pension in retirement.
This is because a market downturn that results in low or negative returns on what is likely to be a sizeable pension pot by that stage can erode its overall value, with considerably less time to make up the difference compared to someone at the beginning of their pension saving journey.
Therefore, it is vital to seek the retirement planning advice of a financial adviser before clocking off forever to ensure your retirement nest egg is as healthy as possible and isn’t unduly affected by sequence risk.
Pension drawdowns provide retirees with a flexible means of drawing a retirement income to suit their needs. However, there are some inherent pension withdrawal risks associated with income drawdown. Not least the very real threat of pension fund depletion at the hands of market fluctuations, sequence risk and overspending.
However, our advisers at Hilltop Financial Planning are here to give you all the facts you need to make an informed decision about whether or not pension drawdowns are a suitable option for you. If it makes sense to go down that route, a combination of careful planning and sustainable withdrawal rates are the key to success.
We can formulate a robust pension drawdown strategy and help alleviate investment risks in retirement, minimising the chances of running out of funds. Contact us to learn more about the pros and cons of pension drawdowns and how the Hilltop team can help you plan for a secure financial future. Get in touch today at 0161 413 7051.
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