What are the main Sipp drawdown risks for investors? We outline strategies to stop you walking a financial tightrope in retirement.
The pension freedoms introduced in 2015 have been well received, particularly by people in their 50s looking to take tax-free cash. But it is early days, and both consumer bodies and the financial services industry are concerned that many self-invested personal pensions (Sipps) are being managed by people without much investment expertise, who are making poor decisions that could have dire consequences for them. Here is some advice on avoiding common mistakes that investors in drawdown often make.
1. Never invest your entire pension pot in cash
Between October 2015 and September 2017, nearly 350,000 people went into Sipp drawdown, and almost a third chose to manage their money without taking any financial advice. Worryingly, almost a third of these people are wholly invested in cash. Over the medium to long term, this means their funds will be eroded by inflation.
UK inflation is currently running at 2.5 per cent, although it is likely to edge higher. But inflation and compounding are a dangerous mix. If inflation were to average 2 per cent a year over 10 years, £1,000 would be worth just £800 at the end of the period, while inflation at 5 per cent would reduce the real value of a pot to £550 over the decade.
The Financial Conduct Authority (FCA) is thinking of banning Sipp holders from investing solely in cash, to deal with this problem. It reckons Sipp investors who are invested in cash could increase the income their pension fund generates by 37 per cent by choosing a more appropriate mix of assets. It suggests an asset mix of 50 per cent equities, 20 per cent government bonds, 20 per cent corporate bonds, 7 per cent property and just 3 per cent cash. As a rule of thumb, most people should have two years of their expected annual income in cash to avoid being a forced seller of investments.
What’s more, in a drawdown plan you may have to pay charges for keeping your pot in cash. You could earn interest of just 0.5 per cent, while charges on the pension fund could be 1 per cent.
‘A wide range of investments are permitted in a Sipp, but many self-investors hold excessively large amounts in cash in the belief that it is the securest investment, even over the long term,’ says Nick Dixon, investment director at Aegon.‘Over a period of five or more years, cash is typically eroded by inflation, so investors should instead look to other asset classes such as equities for higher returns.’
He adds: ‘Where equity funds are held, often the best approach is long-term patience to ride out the highs and lows of markets. However, when markets have already surged upwards, many investors jump on the bandwagon, not wanting to lose out, and acquire assets when market confidence and asset prices are inflated. During times of intense volatility and when markets plunge, there is a tendency for self-investors to panic and sell-out, giving up hope of strong returns.’
2. Don’t resist reinventing your investment strategy
Many Sipp investors stay with familiar strategies and well-known funds that may have served them well in the accumulation stage of their pension plans, such as equity growth funds or old-fashioned equity market trackers. However, these have a lot of market exposure and can fall in value quickly in the event of a market crash, exposing investors to so-called sequence risk. This is where investors are forced to liquidate assets to take income when asset prices have fallen, eroding the capital available to generate future income.
Experts stress the need for wider diversification and monitoring of portfolios, and say investors should resist being buffeted by short-term noise. Dixon says: ‘A lack of confidence contributes to inertia among self-investors, with many remaining invested in expensive funds even when cheaper alternatives are available. Some investors are still paying 1 per cent for tracker funds bought in 2000, when they could track the same index in a fund costing 0.06 per cent.’
For greater diversification, you can allocate to income-generating assets such as sovereign and corporate bonds diversified across different regions and to uncorrelated asset classes such as infrastructure, property, commodities and precious metals. Currently, emerging market debt and US Treasuries stand out as the best value in the bond market, although the former is a less predictable asset class.
Another alternative is absolute return funds such as Invesco Perpetual Global Targeted Returns and BlackRock UK Absolute Alpha, which aim to make a positive return regardless of the direction of the broad stock market.
3. Consider uncrystallised fund pension lump sums
The pension strategy of taking an uncrystallised fund pension lump sum (UFPLS) allows you to draw lump sums directly from your pension from age 55, without making a transfer into a Sipp and moving into drawdown. One quarter of the amount you withdraw will usually be tax-free, while the rest will be taxable.
UFPLS allow simple and easy access to your money held in your pension fund and are good for people with smaller pension funds, as money not withdrawn will continue to be invested in a tax-efficient environment, while they will not be hit with the charges of transferring to another scheme.
If you’re a basic-rate taxpayer, for example, taking an UFPLS every month – a quarter of which is tax-exempt – could save you from paying tax at a higher rate.
There may also be a marginal benefit in UFPLS in making the most of the lifetime allowance, because of the way the calculations are rounded, that could mount up over the years.
4. Be sure to avoid the ‘emergency’ tax trap
Some Sipp investors are being clobbered with high rates of income tax on withdrawals made from their pension pots. This is because HMRC applies an ‘emergency’ tax on the first withdrawal of each new tax year and assesses it as if it is the first of regular monthly payments to be paid over the year, which can take you into a higher tax bracket. For example, HMRC will charge income tax on an initial payment of £10,000 as if you were going to take income of £120,000 a year.
You then have to either wait for HMRC to pay the overpaid tax back or reclaim it. However, the reclaim process is rather time-consuming. There are three relevant forms: form P55 if you have taken a withdrawal but left money in your pension pot; form P53Z if you have emptied your pot but are still in employment; and P50Z for someone who has emptied their pot and is no longer in work.
The solution is to make a small withdrawal at the start of the tax year – £10 will do. This will trigger the emergency tax code. One month later you can take out the lump sum you want, knowing that your tax code, predicated on the earlier smaller payment, will be negligible.
Since the pension freedoms were introduced, tens of thousands of people have had to claim back hundreds of millions of pounds in overpaid tax. Although the government’s Office of Tax Simplification has asked HMRC to look at the system, the HMRC has refused to change it.