Drawdown can be a great pension option as it gives you complete control over how you take your retirement income. However, this flexibility can come at a cost and as a financial adviser, I often see costly errors of judgment.
Common drawdown mistakes include:
- Taking unsustainable withdrawals, i.e. taking too much pension income
- Hastily selling investments when the stock market crashes
- Failing to make the most of tax efficiencies
In this blog, I will explore these common mistakes in more detail, and provide advice to ensure your pension is less Blackpool and more Barbados!
Mistake 1 -Taking too much pension income
According to the Office for National Statistics, there is a 1 in 4 chance you will live into your 90’s.
This means that if you retire in your 60s, your drawdown pension may have to support your retirement for another 30 years, which can put a massive strain on your pension pot. Yes, you may get the full state pension, but the reality is that it may not provide enough for your version of a ‘comfortable’ lifestyle.
The main benefit of drawdown is its flexibility, as it allows you to take as much or as little income as you like. It’s possible to take a higher income during the earlier years of your retirement and then reduce it once the state pension kicks in or you get older and your lifestyle naturally starts to slow down. You can even take your tax-free cash and no income if you are still working or don’t need a pension income.
On to the first pension drawdown mistake that I see far too often – the temptation to take a significant amount of income from the pension fund, resulting in it running out too early. When Flexi Access Drawdown was introduced, this was referred to as the Lamborghini effect; essentially, those who reached 55 or above would go and blow their retirement fund on big-ticket items!
How to mitigate the risk
To avoid depleting your pension pot too early and losing out on potentially valuable investment returns, it’s essential to determine a sensible withdrawal rate. This is simply the amount of income you take divided by the value of your pension.
So, what is a ‘good’ or sustainable withdrawal rate?
This depends on many things, such as the age at which you retire, risk tolerance and other retirement income you may have. Some would argue that a three to five per cent withdrawal rate a year is okay. You may have heard of this as the ‘4% rule’.
For more on the 4% rule, see our helpful blog.
Mistake 2 – investing too cautiously and panicking during stock market crashes
Another error of judgment I often see is investors hastily selling off their investments when an (inevitable) stock market crash occurs. While it’s understandable to panic if you see your pension savings reduced by 20% or more, chances are that the stock market will eventually recover and you will crystallise what were effectively paper losses up until the point you sold.
It’s time for a war story I experienced first-hand as an independent Financial Adviser…
Cast your mind back to March 2020 and the arrival of COVID-19. The stock market was in a precipitous fall and down 30%. The news was full of hyperbolic headlines such as “100 deaths from COVID today”. A client, who was a retired doctor, believed that the world was on the brink and that a further stock market fall was inevitable. He sold his entire portfolio worth £500,000, with the intention of buying back in at a cheaper price.
Lo and behold, the stock market recovered in rapid time. If we assume his investments were down 15% when he sold, that’s a loss of £75,000. Added to this, he bought back in after the recovery at higher prices, so in reality, his losses were probably closer to £100,000! While I’m rounding these numbers, they are not far off.
Trying to time the market, or selling to cash in the hope of buying back in at lower prices, is historically a terrible strategy. Since WW2, the US stock market has lost 20% or more 13 times and yet despite this, the compounded annual growth rate has been almost 10% a year.
Since 1972, a £10,000 investment in the US stock market would have grown to £1.6 million despite catastrophic events such as the banking crisis of 2008, numerous wars and the global pandemic.
Be aware of the potential volatility of your investments
The stock market can seem scary, particularly if you have been burnt in the past.
This is why I always make the following recommendations:
- Have a written investment plan
- Agree on your asset allocation in advance and how much you will allocate to each asset class, such as stocks, fixed income and property.
- Understand the potential volatility of your portfolio.
We have all heard the famous line, ‘past performance is no guide to the future’, and this is true. Who knows what could happen in the future? But it can give you an idea of past performance.
For example, if you are invested in a 60/40 portfolio, (without getting into the merits of this as an investment strategy), in a truly awful year this portfolio could get cut by a third or more as it did in 2008/2009 during the banking crisis.
To learn more about stock market investments, check out our guide.
It would be reasonable to assume that this scenario could occur again, if not worse. If losing a third of your retirement pot is unthinkable, then it’s clear this investment strategy doesn’t suit your tolerance for risk. A guaranteed income via an annuity could be a good solution for you.
Mistake 3 – Failing to take a tax-efficient income from a drawdown pension
With a drawdown, you can take an income to suit your circumstances. This could be taking your tax-free cash as a monthly income, or taking a combination of your tax-free cash and crystallised pension funds.
It’s possible to stipulate exactly how much tax-free cash and taxable income you want to take to maximise tax efficiency and utilise your personal allowance.
Your personal allowance is the first £12,570 of your taxable income, which is tax-free. With this option, you can take taxable income from your pension up to your personal allowance and then take the remainder from your tax-free cash.
Let’s see an example:
- Terrence retired at age 63, and his retirement savings are £200,000.
- His expenses come to £24,000 a year. He has no other forms of income as he has not reached state pension age.
Therefore, Terrence has all his personal allowance remaining, which means the first £12,570 of his income is taxed at 0%.
Using a tax-efficient income, Terrence can withdraw £12,570 from his crystallised pension pot or the taxable side of his pension. Although these funds are classed as taxable income, as it is within his personal allowance, the effective tax rate is 0%.
At the same time, he can take £11,430 from his tax-free cash to make up the remaining amount he needs. By doing this, his effective tax rate would be a whopping 0%!
If Terrence had simply taken this from his tax-free cash, he would have ‘wasted’ the personal allowance which he didn’t need to use. This opportunity cost could be as much as £2,514 (£12,570 x 20% basic rate income tax).
Talk to Heritage Financial Planning and start planning for early retirement today
As the examples in this article show, you should employ a cautious approach when it comes to taking your pension via a drawdown. To make the right retirement planning choices for your circumstances and goals, seeking professional financial advice is essential.
The financial advisers at Heritage Financial Planning can give you independent advice on pension drawdown based on decades of experience. Call us today to arrange a consultation and take control of your retirement planning.
The value of investments and any income from them can fall as well as rise, and you may not get back the original amount invested. Past performance is not a reliable indicator of future performance and should not be relied upon. HM Revenue and Customs practice and the law relating to taxation are complex and subject to individual circumstances and changes which cannot be foreseen. The Financial Conduct Authority does not regulate tax planning.