In this article, we’ll answer your questions about drawdown pension schemes. Drawdown pensions are the popular choice for retirees with substantial pensions who choose not to accept the shockingly low rates of return offered by traditional pension annuity products.
This article does not constitute financial advice.
Why are drawdown pensions suddenly so commonplace?
The drawdown pension is a recent invention that has only existed since 2015. They’re now a widely available product. In the few years since they were launched, the FCA says that over 615,000 retirees have opted for this product at retirement.
The old pension regime
Until 2015, workplace stakeholder pensioners were forced to use their pension pots to buy an annuity, which is a guaranteed annual income for life.
This wasn’t a bad choice decades ago. In the 1990s, a typical male retiree could buy an annuity income of £15 for every £100 spent. Today, that same £100 can only buy an annual income of £5.
Do annuities provide positive returns?
An annuity rate of £5 is particularly galling when you consider that the lump sum you have paid to the annuity provider is being placed in low-yielding bonds, and drip-fed back to you piecemeal. You’re paying a premium (and a profit margin for the annuity firm) just to see your own money being slowly transferred back to you.
To receive even a penny more than you actually put in; you and your spouse would need to survive for over 20 years with a £5 annuity rate.
Why do annuities pay so poorly?
Since the 2008 financial crisis, the Bank of England reduced interest rates to record lows, which depressed the returns of the low-risk investments like government bonds which powered annuities.
At the same time, our life expectancies have lengthened, requiring annuity providers to lower their payouts to ensure that they can make their guaranteed payments over a longer timeframe.
The drawdown ‘solution’
In 2015, the Conservative Chancellor George Osbourne announced his own answer to the issue: he would unlock pensions and give pensioners the flexibility to invest and withdraw their retirement savings as they saw fit. The pension accounts used to do this would be known as drawdown pensions, but their technical name is a Self Invested Personal Pension or SIPP for short.
Of course, this announcement fitted with the Conservative Party ideals of free markets and personal choice, but it crucially provided alternative options for retirees who wanted to be able to say ‘no’ to poor annuity rates and target a larger retirement income.
How does a drawdown pension work?
A drawdown pension is a simple investment account with a pension provider, bank or stockbroker. It can hold cash, shares, bonds and funds. Pretty much any investment you can think of.
The following characteristics of a drawdown pension allow us to tell it apart from a standard investment account:
- The owner will be at least 55 years old
- The source of the money was a personal or workplace pension scheme
- Ordinary withdrawals from the account are treated as taxable income
Drawdown pensions are usually invested in a portfolio of investments, which can be sold at the discretion of the owner, and withdrawn with regular frequency to provide for their lifetime in retirement.
Transferring out of a defined benefit pension scheme – should I take financial advice?
The government mandates that you must seek independent financial advice if you wish to exit a defined benefit pension scheme and transfer to a defined contribution pension scheme.
Defined benefit schemes are varied and complex. They could include attractive rights that would be forfeit if you transferred out. The value of these rights may make that a financially unwise decision.
Generally speaking, most defined benefit schemes offer a generous level of income. They were designed during a period of high stock market growth and promised very high (and sometimes unsustainable) income levels which is why most private sector companies have closed their schemes to new entrants.
The lucky workers who did accrue benefits during those decades usually opt to remain part of the scheme and receive the promised income in retirement.
This article is not financial advice, and therefore if you are considering leaving a defined benefit scheme you should seek a financial adviser.
Managing a defined contribution scheme or buying an annuity – should I take financial advice?
This article assumes that you have one or more defined contribution (DC) schemes, i.e. a pot of money that you and your employer have contributed towards over your working years.
There are three key judgements to make when retiring with a DC scheme. These are the same questions which you could put to a financial adviser:
- Should I take the 25% tax-free lump sum?
- Should I buy an annuity or draw down my pension?
- If I decide to draw down, how should I invest my money and how much income can I safely withdraw each year?
Large pension pots (£500k+)
If you have a very large pension pot (such as £500,000+), it is not likely that the cost of financial advice (£5,000 – £10,000) will significantly reduce the spending power of your pension. Therefore it’s advisable to consult with a professional if you don’t feel well-equipped to answer these questions.
Small pension pots
However, the choice is more balanced for smaller pots. The cost of financial advice is not insignificant, and it could equate to the cost of a luxury holiday for two. It’s natural to question whether financial advice is really necessary when facing this trade-off.
First of all, it’s worth highlighting that only a minority of retirees do seek independent financial advice. It is not essential and many decide that they simply cannot afford to lose such a large chunk of their pension in exchange for advice on how to manage the residual.
The general information you will learn from an adviser and the options you are presented with are already freely available on the web. And of course, there are excellent retirement planning books that will talk you through the most common scenarios for £10.
So for the price of a couple of cups of coffee and a few hours of your time, you can pro-actively fill in many gaps yourself and become more comfortable with the decisions ahead of you.
I would suggest only making the decision to use a financial adviser after you have dedicated some time to use these free options first.
The advantage of a financial adviser is that they will tailor their advice to your precise financial circumstances, in a way that no book or blog post can ever replicate.
However, the vast majority of us have very simple circumstances that require only very simple solutions.
I have decided to take a drawdown pension, what are my next steps?
Your next step will be to choose a financial institution to administer your SIPP pension drawdown account and to decide whether you will take advantage of the special rule that allows you to withdraw 25% of your pension pot as a tax-free lump sum at the date of retirement.
1. Choosing a pension provider for the next chapter
You are not confined to the pension firm you used to build up your workplace pension. You have the freedom to transfer the current value of your pension pot to another provider at any time.
When choosing a provider to serve you during retirement, you’ll want to look for an institution with:
- Clear, concise and helpful language
- Low annual account fees and low charges for buying investments
- A suitable range of fund options that will cater for your needs today and in ten years
- A long trading history and a good reputation
It’s important to pick your provider before you take a tax-free lump sum or begin withdrawing a pension, because some providers may not let you transfer after you begin withdrawals.
2. Deciding whether to take a tax-free lump sum
As we mentioned briefly above, any income withdrawn from a drawdown pension is subject to income tax. The full State pension is currently £185.15 per week or just over £9,600 per year. In contrast, the threshold at which individuals pay income tax on their earnings is £12,570.
This means that anyone on a full state pension and who is withdrawing more than £3,000 per year will probably fall into the bracket of paying income tax.
It’s therefore seen as a smart move to withdraw the tax-free lump sum when given the opportunity. This money can be invested outside the pension scheme in an account of your choosing and treated just like pension money. The only difference would be that you won’t need to declare it on your tax return when you use these funds to supplement your lifestyle.
This article is not tax advice, please refer to the HMRC website for the latest rates and allowances, and consider buying a good tax book to familiarise yourself with taxation. Individual circumstances may vary. To learn more about how investments are taxed read our guide.
3. Discover your risk tolerance and choose suitable investments
There are many excellent risk tolerance questionnaires to help you understand where you sit on the spectrum of conservative to adventurous.
Here are some great questionnaires to try:
When answering the questions in these surveys, you should be considering more than your general disposition towards risk. It’s worth reflecting on how your changing circumstances at retirement may affect the risks you can afford to take.
During your working life, any money lost through stock market dips could easily be made back through a regular salary. But in retirement, you may be reliant upon the extra income from a private pension to maintain your current lifestyle.
Will I need to monitor my investments carefully?
If you invest in a simple investment plan, such as an ‘all-in-one’ fund that contains a mixture of assets, you won’t need to micromanage your pension. Actively managed funds are overseen by an investment team, so you won’t need to obsess over the detailed holdings or track its price movement day by day.
In fact, you are strongly discouraged from monitoring your pension too often because getting too caught up in daily movements is likely to encourage you to overtrade (incurring fees) or jump in and out of the market in an attempt to ‘beat the professionals’. Both strategies do not work for the majority of investors and therefore you will be fine picking a sensible fund and only reconsidering your portfolio once or twice per year.
How much do pension providers charge in fees?
In a pension you will typically pay two types of fee each year:
- A platform charge or account fee (you can see this on your annual statement)
- Investment management fees, paid by the funds you invest in (this is disclosed on the Key Facts sheet for the fund)
If you opt to stick with your existing workplace pension provider, you may be charged a different level of fees than a member of the public who signed up independently, because an employer may negotiate favourable terms for their employees.
You’ll therefore need to ask your current provider what you pay in annual account fees and also the annual management charges for the funds you are currently invested in.
To aide any comparison, here is a summary of the platform fees charged by some of the biggest pension providers in the UK:
- Aviva – Advised Platform Sipp – 0.36%
- Aegon – ARC – 0.52%
- Legal & General – 0.25%
- Prudential – Retirement Account – 0.35%
- Vanguard (k) – 0.15%
On a £250,000 pension pot, each 0.1% of fees equates to £250 per year. This means the most expensive provider above (Aegon), would charge £9,250 extra over a decade compared to the cheapest (Vanguard).
This comparison applies only to the annual account fees; charges within underlying investments and other charges may vary.
In case you haven’t heard of Vanguard. Vanguard is a US-headquartered investment manager with over $7 trillion of assets under management. They are known for their industry-beating fees and are structured like a mutual, so profits are reinvested back into the company, helping it keep its fees low.