How does ‘flexi-access’ drawdown work? Ceri Jones explains and examines how to use it to meet your pension income needs.
Drawdown is a flexible way to access your pension fund, where you decide how much income you want to take out every year. You can take regular withdrawals, the occasional lump sum or a mixture, or simply leave the investment fund to grow. It’s your choice, and you can change your mind as you go.
Not all employers offer their pension scheme members an income drawdown option at retirement, however. Those employers that do are most likely partnering with a drawdown provider such as a life insurance company. Employees who work somewhere without a drawdown option may have to transfer their pension pots to a scheme on the open market such as a self-invested personal pension (Sipp), offered by firms such as interactive investor and Hargreaves Lansdown. All Sipps offer the option of drawdown.
How it works
Once you ‘enter drawdown’ (start to take an income), the pension scheme or provider administers the fund and pays income as cash into your nominated bank account, sending you a payslip whenever it does so. In practice, most people take their entitlement to 25% tax-free cash as a lump sum first, and subsequent withdrawals are taxed at their prevailing rate of income tax, which the scheme deducts in advance.
Large withdrawals could push you into a higher tax band, so bear this in mind when deciding how much to take and when in a tax year. Any income from other sources such as a final salary scheme will be combined with it to calculate your income tax rate as usual.
If you start by withdrawing a large sum, then you may find you temporarily pay higher tax – particularly if the withdrawal is made early in the tax year – as the provider will work on the basis that this is the amount you plan to draw regularly over the rest of the tax year. This may be resolved by the provider taxing later income withdrawals more lightly to bring the tax rate back in line, but sometimes too much tax is deducted and you may have to claim the money back in your annual self-assessment return.
When we talk about pension drawdown today, we are typically talking about the type of arrangement introduced in April 2015, where there is no limit to the income you can take from your drawdown funds. But prior to 2015, the amount one could take out was capped, so that withdrawals could not exceed the Government Actuary Department (GAD) limit by more than 50% in any given pension year – giving an income broadly equivalent to 150% of the amount an average pensioner of the same age could get from a lifetime annuity.
If you don’t want to take all your tax-free cash at once, the pension freedoms regime also allows you to take your pension as ‘uncrystallised funds pension lump sum’ (UFPLS). Most people find this relatively inflexible, however, as you cannot take your tax-free cash separately but must take it in stages, as a quarter of each withdrawal you make. UFPLS was offered as a concession to providers that could not manage the complexities of flexible drawdown but wanted to provide members with some kind of pension freedom. Some schemes do not offer UFPLS.
Drawdown fees are complicated and hard to compare. For example, the administration fee can be a flat fee or charged as a percentage of your fund, in which case it will very often be reduced in steps for the largest portfolios. There is also a range of other charges and fees to compare.
There may be different administration charges for unit trusts than for shares or other assets. There are also set-up charges, fees on the underlying investments and, if used, fees for discretionary management, plus charges for withdrawals, dividend reinvestment, transfers in and out of your account, and account closures.
Platform consultancy The Lang Cat is a good reference source for making comparisons, depending on the size and profile of your pension fund and flexibility requirements.
For example, Hargreaves Lansdown charges 0.45% of assets invested in open-ended funds, falling to 0.25% for fund assets worth between £250,000 and £1 million, and to 0.1% for fund assets worth between £1 million and £2 million. A platform charging flat fees can be more attractive for larger portfolios. Interactive investor charges a fixed monthly ‘service plan’ fee, starting at £9.99 a month and including one free trade a month, plus a Sipp platform fee of £10 per month.
If you want to hold assets other than funds or stocks, such as commercial property, you will need to open a ‘full service’ Sipp with a firm such as Curtis Banks or James Hay, and your basic administration costs could double.
Earlier this year, Vanguard also entered the market with an annual platform charge of 0.15% a year, capped at £375; but investments must be made in Vanguard’s 77 funds, most of which are passive.
The burden of managing the investments yourself obviously comes with risks. Your investments could drop in value or you could live longer than you’ve planned for, with the danger you run out of money. One particular risk is in taking out too much in the early years, or at times when investment returns are poor.
Professional advisers often suggest you try to live off the investment’s natural income, which means dividends and interest – not too easy in these current times. Businesses have cut or suspended £30 billion in dividends this year so far.
Unless you have relevant expertise, you may prefer to ask a discretionary adviser to manage your investments for you. This can be expensive and the results variable. Even blue-chip firms can advise poorly, sometimes pushing clients into ‘big name’ investment funds, or outmoded solutions. For example, some advisers and Sipp platforms were herding clients into Neil Woodford’s Woodford Equity Income fund until days before it was gated last June. Most Sipp platforms also offer free fund recommendations and model portfolios, but many are still based around unit trusts full of stocks that have already cut their dividends.
Sipp including drawdown
Notes: Drawdown charges: (1) £25+VAT one-off income payment + £100+VAT pa regular income payment. (2) £25+VAT one-off income payment + £100+VAT pa regular income payment. (3) For portfolios <£100k: £100+VAT initial calculation fee + £100+VAT annual charge for income; £100k plus: £90+VAT initial calculation fee only. (4) £150+VAT. Each benefit crystallisation event+ £50+VAT annual payroll fee. (5) No additional charges for drawdown. (6) £180+VAT pa. (7) No additional charges for drawdown. (8) £10 per month (inc VAT). (9) £180+VAT pa (10) No additional charges for drawdown. Source: The Lang Cat, as at 23 May 2020.
As you get older, you may not want the hassle of monitoring your portfolio, and at this stage you may be inclined to invest in an annuity to pay you a guaranteed monthly income for the rest of your days. The advantage is that you will then be older, perhaps with a medical condition, and should be able to obtain a higher income than you could earlier on in your retirement.
The disadvantage is that you could die immediately, which would mean that you would not be able to leave your fund to your beneficiaries. There are some annuities which offer some residual value if you die, but if you choose this option you will receive a lower regular income.
One of the advantages of drawdown is that up until age 75 you can leave your pension fund to your beneficiaries completely free of tax. However, your beneficiaries must take the money within two years of the provider becoming aware of your death. If the deadline is missed, the legacy is automatically added to your beneficiaries’ income and taxed at their highest marginal rate.
If you die after age 75, the funds are still free of inheritance tax but payments will usually be taxed as income at the beneficiaries’ marginal rate.
There is a lifetime allowance on pension savings, which is the limit on the total value of payouts from your pension schemes (but excluding your state pension) that can be made without triggering an extra tax charge. For the 2020/21 tax year, this is £1,073,100. When you first make a withdrawal, the fund’s value at that point is compared against your lifetime allowance to see if there is additional tax to pay. An additional check will also take place on your 75th birthday, which will measure any unused funds against your remaining allowance.
If your pension fund value is nudging against the lifetime allowance, this is the one situation where UFPLS might be slightly advantageous. This is because calculations as to how far the lifetime allowance has been used up are calculated and then rounded down (marginally reducing the value of allowance remaining). A flexible drawdown payment of income and tax-free cash involves two roundings down, while UFPLS allows just one, which can make a surprising difference when repeated many times as income is taken over the years.