Retirees can now take regular income from their pension pots. However, calculating how much drawdown is sustainable is a complex – and crucial – task.
More than three years after radical pension freedoms were introduced, the popularity of pension drawdown remains undiminished. Drawdown allows an investor to leave their pension fund invested and take income from it, rather than use it to buy an annuity paying income for life . But how sustainable are the withdrawal levels being seen?
It’s not easy to get a clear picture on drawdown. AJ Bell reports that 41 per cent of people in drawdown are withdrawing more than 10 per cent of their funds each year, while Aegon reports that the average level of annual drawdown is 5.2 per cent. However, to set these figures in context, withdrawals under the pension freedoms only account for around 30 per cent of total retirement income, as most people still have other sources of income such as final salary pensions. Moreover, while withdrawal levels might seem high given rising life expectancies, they have been supported by a benign stock market.
Here we look at how drawdown has been working so far, and consider the factors shaping its use and the likelihood that investors will have to modify their expectations and behaviour in years to come.
Income drawdown has been popular for several reasons, such as the flexibility it offers and the widespread lack of trust in the pensions industry. Jonathon Webb, pensions consultant at financial consultant Montfort, argues that the ‘poor value’ offered by traditional annuities – even impaired or enhanced annuities that tend to pay more generously – has led people to believe they can maintain a higher income from pension savings by taking a prudent level of withdrawals.
However, Fiona Tait, technical director at Intelligent Pensions, says it’s worrying that ‘people take out their lump sum to put into cash’, as their pension won’t even keep up with inflation and they will lose out on pension tax breaks.
Meanwhile, some retirees need their pots to be sustainable for just a fixed period, after which they will rely on other assets such as equity release or final salary benefits, argues Kim Lerche-Thomsen, chief executive at Primetime Retirement. ‘But others will withdraw lower sums and accept lifestyle limitations out of fear of running out of money,’ he adds.
The average percentage currently being taken out of pensions is estimated to be 5.2 per cent a year, according to the Financial Conduct Authority, but this figure may not be ideal in terms of sustainability. Jeannie Boyle, director and chartered financial planner at EQ Investors, says: ‘This [5.2 per cent] probably sounds very reasonable, but research shows that a starting rate of 3.5 per cent is more likely to be sustainable if you want an inflation increase each year.’
Tait points out that settling on a particular withdrawal figure wrongly suggests that investors only need to work their sums out once. She says: ‘Instead, they need to regularly look to see what’s happening to their fund.’ She adds that 3 per cent ‘is fine as a parameter, but you’d be mistaken in thinking people won’t run out of money if they just stick to it’. When people were still obliged to buy an annuity, their decision was made once. Today pensions require regular monitoring.
Natanje Holt, a retirement specialist at Bravura Solutions, says: ‘There are many unknowns when we look at drawdown, and while you can start with a logical approach to work through it, emotional considerations quickly come into play.’ Trying to make a pension last without knowing how long it will be needed is tricky, especially if you want to maintain a decent standard of living or leave money to relatives.
Consider the variables
What counts as a sustainable drawdown rate depends on the pension investment portfolio’s returns, the drawdown recipient’s longevity and inflation, all of which will vary over time. Currently, life expectancy in the UK is 78 for men and 82 for women. Over the decades, life spans have increased to a point where about two-thirds of those born now are likely to live to 100. Meanwhile, inflation is rising by 2.5 per cent a year, while the UK economy slowed to a standstill in the first quarter of 2018, with the GDP growth rate just 0.1 per cent.
More significant for pension investors, though, is market sentiment. Markets have been kind to investors during the first few years of pension freedom. However, Boyle says: ‘It’s easy to imagine a scenario in which markets are less benign and investors find their pots draining too quickly.’
Indeed, one of biggest dangers to people’s retirement pots is the impact of so-called pound-cost ravaging. The term describes the negative effect of continuing regular withdrawals during and after markets have fallen. When people keep taking a fixed sum while the market and their underlying investments fall in value, more units have to be sold to cover the amount of income being taken.
With progressively fewer units in the pension pot, it becomes increasingly difficult for it to recover. If a person makes withdrawals at an early stage of retirement and during an economic downturn, the consequences can be particularly dire. As Boyle says: ‘Investment returns in the first few years have the biggest impact on the level of income over the next 20 to 30 years.’
So what precautions can investors take in a downturn? Ideally, they should maintain a cash buffer to use if the market takes a plunge, so that they can allow their pot to recover before they take further income from it. However, not everyone can afford the luxury of a cash buffer.
For those who don’t have large reserves, there are alternatives. Holt says: ‘If you can find part-time work and delay tapping into your savings, you can help your funds recover.’
Alistair Wilson, Zurich’s head of retail platform strategy, argues that more needs to be done to understand whether or not people who are not getting financial advice are taking a sustainable income. He says: ‘Although it’s still early days, our research has found that two in five people in drawdown are withdrawing the same amount regardless of how the stock market has performed.’ He agrees that withdrawing more than the investment return from a portfolio or selling investments after markets have fallen leaves people unable to make up losses and shrinks their pension fund, which further restricts its future growth.
That’s why Wilson recommends that savers in drawdown should constantly modify their expectations and behaviour in line with the stock market. He says: ‘It’s crucial that consumers understand the importance of carefully controlling their withdrawals and remaining flexible about their income throughout retirement.’ He adds that when markets struggle, investors should scale back their withdrawals or place them on hold until they have recovered. ‘Alternatively, [investors could] limit the level of withdrawal to the “natural” income from share dividends or bonds.’
Advisers can make predictions, but they are hindered by the fact that market conditions can undermine even the most carefully planned withdrawal models, argues Lerche-Thomsen. He says: ‘Fundamentally, people are often reliant on their pension pots for longer than they have saved for, making cash-flow modelling on a collective basis difficult and modelling for an individual almost impossible.’
He adds that the solution is to ‘assemble a flexible strategy able to withstand unpredictable major events while providing financial certainty’. This strategy will include other sources of income such as Isas, the state pension, final salary pensions and, potentially, a small annuity as safety buffers.
Time will tell how flexi-drawdown develops further as its early users age. Research by Zurich shows that nearly nine in 10 people (86 per cent) are not worried about how they will manage with drawdown in later life.
Wilson says: ‘While this is positive in the main, consumers should plan ahead for a time when looking after their investments might become more difficult, or even impossible.’
Claire Trott, head of pensions strategy at Technical Connection, argues that the true impact of taking income from pension investments won’t be seen for many years. ‘Those with the larger funds, who would always have chosen drawdown, aren’t of primary concern,’ Trott says. She stresses that we should be more concerned about those with smaller funds who need the security of a regular income and may need further education or protection to ensure their funds do not run out in retirement.
However, she says: ‘We should not forget that this is their money and the freedoms were designed to encourage greater engagement with their financial futures. This has been achieved, to some extent at least.’
Five ideas to boost your retirement income
For those approaching retirement, Fiona Tait, technical director at Intelligent Pensions, has five valuable tips for increasing your income in retirement:
1. Check your state pension entitlement. You can get a forecast from the Department for Work and Pensions at: www.gov.uk/check-state-pension.
2. Increase your eventual state pension. You will only get the full new state pension if you have paid 35 years of national insurance contributions. You can check your contribution record and if you have any gaps, you can make voluntary contributions to top it up.
3. Defer your state pension. If you can afford to, you can increase your eventual state pension by deferring it. For every year that you delay taking it, you will receive an increase in your state pension income of 5.8 per cent. Details are available here.
4 Track down all your occupational pensions. The average person will hold six different jobs during their lifetime, and one or more may have a pension attached that they have forgotten about. You can use the government’s pension tracing service to find them.
5. Consider using non-pension savings. Pensions are specifically designed to produce an income when you stop working. However, the reality is that they are at their most tax-efficient while still invested. If you have other savings, such as Isas, it may make sense to use these up first and delay taking your pension.