Taking Your Pension
When you decide to start drawing on your pension, you then have a number of choices to make. You could buy an 'Annuity', which used to be the only option until the pension reforms that happened a few years ago. Or alternatively you could look at 'Drawdown' as an option. So what is the difference?
With an annuity, you essentially exchange the money saved in your pension for a guaranteed income for life. There are variations on this, such as buying an income that increases with age, or pays out to a spouse upon your death etc. These annuities are sold by insurance companies and you have to shop around and try and get the best quote you can. Personally, I'm not a fan of these as I don't believe you get good value. For example, at the moment annuity rates are less than 4%, which means for every £100,000 you can get a lifetime annuity of £4000 per year. To be clear, you GIVE the whole £100,000 to an insurance company who then pays you £4000 per year until you die. So if you die in less than 25 years, you don't even get your full £100,000 back! OK, so why would anyone actually choose this option? Well, it is guaranteed and you know exactly what you will get without having to worry about any changes in stock market or interest rates. For this reason, some people suggest buying an annuity to cover your basic costs and then using the rest in drawdown. So let's look at 'Drawdown' as an option.
Moving your pension fund to Drawdown is essentially leaving it where it is, but having access to it to draw off an income. For many people this may be the preferred option as currently it is possible to find funds that will pay a natural yield of around 4%, which means that you can beat an annuity and still keep the capital. Drawdown therefore offers great flexibility, the potential of an increasing income as well as the chance to pass on more of your pension when you die as your pension becomes part of your estate unlike an annuity.
Obviously there is the risk with this approach that you cannot always achieve a natural yield of 4%. If the yield goes down then clearly the amount you can draw from your pension(without affecting the capital) will also go down. If the funds you are invested in also fall, then the capital will also fall and even if you maintain a yield of 4%, this will produce a lower income as the markets drop. So Drawdown is a riskier option than an Annuity. However, there are three ways in which you can mitigate this risk:
1) Keep a Cash Buffer
Whilst it is always a good idea to have some cash set aside for a rainy day, you also need to make sure that you have enough to cover your essential spending for the short term. Having a cash buffer can help shelter you against falling markets, so that you can reduce or stop income withdrawals for a while until the market recovers. This will help maintain your pension capital and allow it to recover. The amount of cash you hold will depend on how much you want to mitigate the risk, but you should be looking at holding anything between 6 months and 2 years of cash for essential expenses. This cash can be held in a mixture of easy access and fixed term accounts to maximise the interest you can get. You could for instance have 6 months worth of cash in an easy access account and then further cash in a number of 6 month or 1 year fixed interest accounts. History has shown us that markets generally move back in an upwards direction given enough time, and so reducing your pension withdrawals for a short time during adverse market conditions can be a very effective risk mitigation strategy.
2) Diversification
Diversification is one of the cornerstones of successful investing because it can significantly help to reduce risk. We have all heard the expression ‘don’t put all your eggs in one basket’, and this couldn't be more true when it comes to your pension portfolio. Depending on your own attitude to risk, a diverse and balanced portfolio will include a mixture of different asset types, such as equities and bonds (remember, bonds tend to be less volatile). Different types of markets and sectors perform better at different times, and it is this that can shelter your overall pension value during market falls, and help provide more consistent performance. If you don’t feel as though your current portfolio is appropriately diversified, this doesn’t mean you should necessarily sell, especially straight after a market fall. You might want to think about gradually taking steps towards your diversification goal when you feel the time is right. You should also periodically review your portfolio to make sure it meets your objectives (e.g. natural yield) and attitude to risk (e.g. equities or bonds). You could consider options such as switching from assets which have done well into those which you think have strong potential. Ongoing review of your pension can help maintain a balanced and diversified portfolio.
3) Sustainable Withdrawals
Make sure that your withdrawals from your pension are sustainable. This is where the 'Natural Yield' approach really helps. We are all living longer and if you are aiming to retire at 55, then you could be looking at drawing from your pension for 40 or more years. By only drawing the natural yield, you can be confident that your pension will last for your whole retirement.
Whether you decide on an annuity or drawdown, you still have the option of taking up to 25% of your pension tax free. This can be either as a lump sum, or for every withdrawal you make. Taking it as a lump sum can be a great way to buy that fancy sports car you always wanted! But better still, you could invest some or all of it into an ISA to provide further tax free income.
You may not realise this, but when you start drawing money from your pension (either via an annuity or drawdown), apart from the initial 25% tax free amount, anything else is subject to normal income tax. You still have the normal tax free amount you can earn before paying basic rate income tax (currently £12,500 per year), but if your 4% natural yield strategy is paying you an income greater than this, you could be subject to paying some tax on your hard earned pension.
Let's say you have £500,000 in your pension fund that you have moved in to drawdown. You are following a natural yield strategy and have invested in funds that are paying you a yield of 4%. This means that you will 'earn' £20,000 per year. Unfortunately, £7,500 of this will be subject to tax at the basic rate and so you will lose around £1,500 that will go to the tax man.
If on the other hand, you take your 25% tax free from your pension (£125,000) and move that to an ISA, then the money you will earn from your pension is less (£15,000), and your tax burden is reduced. Remember, anything you earn from an ISA is tax free, and so this can help reduce your tax burden. Timing can be important here, as you only have an allowance of £20,000 each year for contributing to an ISA. However, if you take your 25% tax free in March, you can contribute to this year's ISA and then wait until April to contribute to the following year's ISA. Now if you are married you can then contribute £80,000 into ISAs over March and April. Anything left can be saved for the following year, either in a 1 year fixed interest account, a non ISA stocks and Shares account or elsewhere.
Another point to be aware of is that with drawdown, you are in control of how much you withdraw, so even if your 4% natural yield strategy would pay you more than your tax free allowance, you don't have to draw it all out. You are only taxed on what you take out. So you could take out just enough to avoid paying tax.
The amounts used in these examples are just to help demonstrate some ideas. It may be that your pension pot is larger or smaller than this example, however, the principle remains the same and it is worth looking at the numbers to understand any potential tax implications once you start drawing from your pension.
With an annuity, you essentially exchange the money saved in your pension for a guaranteed income for life. There are variations on this, such as buying an income that increases with age, or pays out to a spouse upon your death etc. These annuities are sold by insurance companies and you have to shop around and try and get the best quote you can. Personally, I'm not a fan of these as I don't believe you get good value. For example, at the moment annuity rates are less than 4%, which means for every £100,000 you can get a lifetime annuity of £4000 per year. To be clear, you GIVE the whole £100,000 to an insurance company who then pays you £4000 per year until you die. So if you die in less than 25 years, you don't even get your full £100,000 back! OK, so why would anyone actually choose this option? Well, it is guaranteed and you know exactly what you will get without having to worry about any changes in stock market or interest rates. For this reason, some people suggest buying an annuity to cover your basic costs and then using the rest in drawdown. So let's look at 'Drawdown' as an option.
Moving your pension fund to Drawdown is essentially leaving it where it is, but having access to it to draw off an income. For many people this may be the preferred option as currently it is possible to find funds that will pay a natural yield of around 4%, which means that you can beat an annuity and still keep the capital. Drawdown therefore offers great flexibility, the potential of an increasing income as well as the chance to pass on more of your pension when you die as your pension becomes part of your estate unlike an annuity.
Obviously there is the risk with this approach that you cannot always achieve a natural yield of 4%. If the yield goes down then clearly the amount you can draw from your pension(without affecting the capital) will also go down. If the funds you are invested in also fall, then the capital will also fall and even if you maintain a yield of 4%, this will produce a lower income as the markets drop. So Drawdown is a riskier option than an Annuity. However, there are three ways in which you can mitigate this risk:
1) Keep a Cash Buffer
Whilst it is always a good idea to have some cash set aside for a rainy day, you also need to make sure that you have enough to cover your essential spending for the short term. Having a cash buffer can help shelter you against falling markets, so that you can reduce or stop income withdrawals for a while until the market recovers. This will help maintain your pension capital and allow it to recover. The amount of cash you hold will depend on how much you want to mitigate the risk, but you should be looking at holding anything between 6 months and 2 years of cash for essential expenses. This cash can be held in a mixture of easy access and fixed term accounts to maximise the interest you can get. You could for instance have 6 months worth of cash in an easy access account and then further cash in a number of 6 month or 1 year fixed interest accounts. History has shown us that markets generally move back in an upwards direction given enough time, and so reducing your pension withdrawals for a short time during adverse market conditions can be a very effective risk mitigation strategy.
2) Diversification
Diversification is one of the cornerstones of successful investing because it can significantly help to reduce risk. We have all heard the expression ‘don’t put all your eggs in one basket’, and this couldn't be more true when it comes to your pension portfolio. Depending on your own attitude to risk, a diverse and balanced portfolio will include a mixture of different asset types, such as equities and bonds (remember, bonds tend to be less volatile). Different types of markets and sectors perform better at different times, and it is this that can shelter your overall pension value during market falls, and help provide more consistent performance. If you don’t feel as though your current portfolio is appropriately diversified, this doesn’t mean you should necessarily sell, especially straight after a market fall. You might want to think about gradually taking steps towards your diversification goal when you feel the time is right. You should also periodically review your portfolio to make sure it meets your objectives (e.g. natural yield) and attitude to risk (e.g. equities or bonds). You could consider options such as switching from assets which have done well into those which you think have strong potential. Ongoing review of your pension can help maintain a balanced and diversified portfolio.
3) Sustainable Withdrawals
Make sure that your withdrawals from your pension are sustainable. This is where the 'Natural Yield' approach really helps. We are all living longer and if you are aiming to retire at 55, then you could be looking at drawing from your pension for 40 or more years. By only drawing the natural yield, you can be confident that your pension will last for your whole retirement.
Whether you decide on an annuity or drawdown, you still have the option of taking up to 25% of your pension tax free. This can be either as a lump sum, or for every withdrawal you make. Taking it as a lump sum can be a great way to buy that fancy sports car you always wanted! But better still, you could invest some or all of it into an ISA to provide further tax free income.
You may not realise this, but when you start drawing money from your pension (either via an annuity or drawdown), apart from the initial 25% tax free amount, anything else is subject to normal income tax. You still have the normal tax free amount you can earn before paying basic rate income tax (currently £12,500 per year), but if your 4% natural yield strategy is paying you an income greater than this, you could be subject to paying some tax on your hard earned pension.
Let's say you have £500,000 in your pension fund that you have moved in to drawdown. You are following a natural yield strategy and have invested in funds that are paying you a yield of 4%. This means that you will 'earn' £20,000 per year. Unfortunately, £7,500 of this will be subject to tax at the basic rate and so you will lose around £1,500 that will go to the tax man.
If on the other hand, you take your 25% tax free from your pension (£125,000) and move that to an ISA, then the money you will earn from your pension is less (£15,000), and your tax burden is reduced. Remember, anything you earn from an ISA is tax free, and so this can help reduce your tax burden. Timing can be important here, as you only have an allowance of £20,000 each year for contributing to an ISA. However, if you take your 25% tax free in March, you can contribute to this year's ISA and then wait until April to contribute to the following year's ISA. Now if you are married you can then contribute £80,000 into ISAs over March and April. Anything left can be saved for the following year, either in a 1 year fixed interest account, a non ISA stocks and Shares account or elsewhere.
Another point to be aware of is that with drawdown, you are in control of how much you withdraw, so even if your 4% natural yield strategy would pay you more than your tax free allowance, you don't have to draw it all out. You are only taxed on what you take out. So you could take out just enough to avoid paying tax.
The amounts used in these examples are just to help demonstrate some ideas. It may be that your pension pot is larger or smaller than this example, however, the principle remains the same and it is worth looking at the numbers to understand any potential tax implications once you start drawing from your pension.