Not Enough or Too Much – The risks of Pension Drawdown

For many people approaching retirement, there is a sense of dread when it comes to navigating the rules about accessing their pensions. In recent years, Pension drawdown, particularly Flexi-access drawdown (FAD), has grown in popularity. FAD enables savers to take a tax-free lump sum from their pension fund and keep the remainder of the money invested to provide an income during retirement.

According to the figures from the Financial Conduct Authority (FCA), three times the number of savers opt for drawdown plans than those buying annuities. However, it is vital retirees understand the risks. A few wrong moves and you could be left with next to no income in later retirement or it could be you are too cautious and surrender having a comfortable later life when you do not need to.

There are risks associated with all retirement income routes, but FAD is a particularly complicated system to navigate due to the variety of risks and the flexibility on offer. Arguably the biggest danger in FAD is to people who plough on regardless of any investment hits and just hope for the best. You need to be flexible and prepared to adjust income in order to ensure your strategy remains sustainable.

What do you need to look out for when accessing your retirement funds?

One of the biggest risks with FAD is running out of money. You can exhaust your pot more quickly than expected if you take income at an unsustainable rate, have insufficient growth from the assets or experience ‘sequence of return’ risk, this is where market falls and heavy withdrawals early in a person’s retirement limits the longevity of their funds.

However, the list does not end there. Some people will be too cautious managing their investments and take too little income, meaning they leave a massive fund behind.

There is also longevity risk, which occurs from people underestimating their life expectancy, and the risk of incurring a hefty tax bill by taking too much income and being snared by the money purchase annual allowance (MPAA) if you take pension benefits and continue to contribute to the pot!

It is my view that stock market crashes have been the biggest issue for our clients. If we look at the Covid crash in March last year, some assets fell by more than 20% really quickly and did not recover until October. Continuing to draw income in this environment would have required proportionately 20% more assets to be sold to produce the same income. In our advice process, we always recommend clients to hold a minimum emergency cash reserve, separate from the pension and in some cases, we had to recommend some clients stop drawing from the FAD until markets recovered.

When things finally recovered later in the year, we saw some clients restart the income and, if it was possible, topped up their cash reserves if they felt the need.

Going it alone

As drawdown is an invested solution, it must be managed regularly, but it is its inherent flexibility and control over the income stream which appeals to most. However, unless an individual is an experienced investor and knows exactly what they are doing, we always recommended you seek help and advice from your Prosperis adviser. Crucially, it is important an income withdrawal strategy is decided on and reviewed regularly to ensure enough money is left in your retirement funds at all times.

As an example, I want to tell you about a client who was in FAD taking a significant income of £20,000 per year when the pandemic hit. We ran a cash flow analysis for her and decided the reasons to continue to draw this amount of income were no longer valid. We identified and quantified her position quickly and, in doing so, we recommended reducing the income by three quarters (i.e. £5,000). As a result, my client avoided selling units in her fund at low points in the market. The income was never going to be spent anyway (lockdown was in full force), but any income would have been taxed at her highest marginal rate only to languish in a low return cash account.

This revised strategy helped maintain the value in her retirement fund, the value saved more than paid for the whole year of advice fees alone. My client restarted her income draw again in November, albeit not at the previous level.

Prior to pension freedoms, the drawdown route was only available to the wealthiest pension savers. With the introduction of FAD in 2015, many professionals will tell you it is far too dangerous for the average person to attempt this without taking professional advice.

The Covid Effect

The importance of having an adviser (and their worth) was demonstrated when the pandemic hit as many investors wrongly rushed to sell down investments as the markets fell. There were some clients who panicked when they saw the markets falling and chose to ‘cash out’ by switching funds to cash. In doing so, this crystallised losses and missed out on the upside immediately afterwards, much to their detriment. The pandemic’s market shock highlighted one of the biggest disadvantages of FAD compared to an annuity, which provides a guaranteed income.

For clients who spoke to our advisers, the general tactic was to manage the issue in the short term, but crucially not to run to cash. Clients who stayed invested have generally been rewarded with a significant swing back of markets, with many finishing ahead of where they started 2020. To me, this really demonstrates the benefits of professional financial advice.

For further information, please speak to your Prosperis adviser 01423 223640 or email us below.