We are now over a year into the new, more flexible, pensions legislation and a clearer picture is starting to emerge around how people are taking advantage of their new found freedom.
In simple terms, the new legislation allows people unrestricted access to their pension funds via a series of withdrawals from the fund, as an alternative to the long-standing norm of purchasing an annuity, which then provided an income for life.
What has become obvious is that, on the whole, individuals are being sensible with their accumulated pension funds with the vast majority of people (57%) withdrawing less than 1% of their total fund in the most recent quarter according to the Association of British Insurers (ABI).
There are however, some signs of more worrying trends, with 4% of drawdown pension pots having 10% of more taken from them in a single quarter. The ABI is keen to point out that these figures may be down to people with several smaller pots taking larger withdrawals from just one of them, but it is reasonably obvious that withdrawals of this magnitude will not be sustainable in the longer term.
While the freedom of being able to use your pension funds as you see fit is no doubt attractive to many, this freedom does come with a potentially significant price – the possibility that ones pension fund may dry up in the future.
You see, in the ‘old world’, people would reach retirement, cash in their pension funds and then purchase an annuity, which guaranteed a modest, but fixed income for the rest of that persons life. It was also possible to build in benefits for a spouse for added security.
Under the new rules, a large percentage of people are selecting a ‘flexi-access drawdown’ pension, where by the pension funds remain invested and withdrawals are taken directly from the pot of money accumulated.
While people are undoubtedly attracted by the flexibility and freedom that these plans afford, the risk with this approach is that if investment performance is not satisfactory, or withdrawals are taking too aggressively, there is the very real possibility that the pension pot depletes over time.
Given the low annuity rates on offer in the present market, it looks likely that the trend towards the ‘flexi-access drawdown’ pension will continue, and this option can be very attractive if managed correctly. Some potential things to consider are as follows:
- Longevity – many people underestimate how long they are likely to live, but over-estimate how healthy they will be during their remaining years. This can be a dangerous combination, given that many people will base the amount they will draw from their pension each year on their estimated life expectancy.
- Investment Risk – we have seen many cases where people have carried a fairly adventurous investment strategy into their retirement years via a drawdown pension. While an investment strategy might be suitable during the accumulation phase, once withdrawals are being made from a fund it can often be wise to review the investment allocation and consider investing in more cautious and consistent assets.
- Timing the Markets – while we believe that no-one can ‘time’ the markets, the timing of withdrawals can have a big impact on the final pension fund one might enjoy. For example, if a share is currently trading at £1 per share and you would like £10 of income, you would need to sell 10 shares. If those same shares were later trading at just 50p per share, we now have to sell 20 shares to generate the same income, leaving fewer shares to hopefully recover in price later on. As such, it can be wise to hold a substantial cash buffer (perhaps one or two years worth of income payments) within your pension to fund withdrawals during times when the market is not looking so healthy.
In our work with clients, we consider all of the above issues, as well as many others in order to design a sustainable and low risk investment strategy, which is specifically tailored to the ‘drawdown’ phase of retirement. The make up of these portfolios is often very different from those used in the accumulation phase of retirement planning.
Buckingham Gate Chartered Financial Planners
18 Buckingham Gate, London SW1E 6LB
Phone: 020 3478 2160