When it comes to your retirement and deciding how to take money out of your pension you may be opting for pension drawdown, but are you aware of the dangers of pension drawdown?
You may have heard that the alternative is going for an annuity, and you don’t like the sound of that because annuity rates are low and your family receives nothing on your death?
Well, that may be true for some and pension drawdown may definitely be the right solution for you, but are you clear on all the facts?
Pension drawdown is not an easy retirement income solution to live with.
It wasn’t long ago that you didn’t have to worry about the dangers of pension drawdown
Before 2015 most people had one choice when they decided to retire……. “what type of pension annuity shall I buy?”
Even then most people still opted to go for whatever offer was made by their pension company.
If you are not sure what a pension annuity is, it’s basically when you agree to give up your pension pot for a guaranteed income for life.
It got a bad reputation because it was so inflexible.
You knew where you stood in terms of the income never running out but you couldn’t change the income once you started. If you died early your family could be left with nothing.
What changed in 2015 was ‘Pension Freedoms’. It was announced that you would be put back in control of your pension and would never need to buy an annuity again if you didn’t want to.
So what was the alternative? Pension drawdown.
This is where you retain access to your pension pot for the rest of your life and make withdrawals from it as and when you want to.
But with this new found flexibility came more responsibility.
Opting for pension drawdown means
- You can spend more during the early years of your retirement and less in the later years.
- You can take out large lump sums if required.
- You don’t have to touch your pension pot at all if you don’t need it.
- You can leave your family a large lump sum on your death.
But with pension drawdown, you have more decisions to make and more risks to worry about.
It’s down to you whether the money lasts the rest of your life and gives you the retirement lifestyle you desire.
6 dangers of pension drawdown
#1 – A large fall in the value of your investments
There will always be a stock market crash at some point in your investing journey. In fact, there will probably be a few.
What did your portfolio look like in 2008?
How will you feel when your pension drops in value by 20%, 30% or more? Especially at a time you need to make a withdrawal to cover your cost of living.
As an example, if your pension was to fall in value by 40% it would take a gain of 67% to get back to where you were.
But if you had withdrawn 5% at the time your pension fell 40%, it would need a gain of 82% to fully recover your losses.
#2 – The less extreme ups and downs of the stock market
Whilst a stock market crash may only happen a couple of times during your lifetime. There will always be good years and bad years.
Each year your pension goes down a little it takes more to get the value back up again.
A 10% fall followed by a 10% gain still means your pension is 1% below where it started. Compound this over time and add in the withdrawals you may need and the volatility drag is going to be tough.
#3 – Getting better investment returns later rather than earlier
When you retire and start taking an income from your drawdown pension it can have a massive effect. Especially depending on what stage the stock market cycle is in.
Getting better invest returns during the early years of your retirement is going to greatly increase the chance of your money not running out, than if you received better returns towards the end.
This is also known as sequencing risk.
#4 – Needing more income during periods of bad returns
Sometimes you will have no choice as to when you will need to withdraw from your pension.
You may need to take out a large lump sum for an emergency repair or you may require a regular withdrawal each month as your pension could be your only source of retirement funds.
By making withdrawals from your pension when the stock markets are down means selling more units to generate the income you need.
Over time this is going to eat away at your overall pot meaning it could run out sooner than you think.
This is known as ‘pound cost ravaging’.
#5 – Inflation
Inflation is the rate at which the prices of goods and services increase.
Think back to when you were younger. The price you paid for your house, food and car were all lower than today.
Over time prices will keep going up which means you are going to require more and more income from your pension just to maintain the same standard of living. This, in turn, means you need to achieve good investment returns above inflation.
#6 – Living longer than expected
Whilst it’s debatable whether living longer is a good thing, the fact is we are.
This means your pension needs to last longer than you may originally have intended.
The worst part is that you don’t know when you are going to die and therefore it is extremely difficult to know how to wind down your pension pot.
Take too much too early on and you could leave yourself short in later life. Take too little early on and you could end up dying and leaving a massive pot that you never got to benefit from.
So as you can see pension drawdown, for all its flexibility comes with some significant work and worry.
Here at RTS Financial Planning, we do not favour annuity or pension drawdown either way as both have their advantages and disadvantages. It will all depend on your individual circumstances as to what is right for you.
We can certainly help you decide though.
Next week I will be writing about how you can manage and mitigate the 6 dangers of pension drawdown. If you would like to find out more about planning for your retirement and your retirement choices please join our Financial Freedom Club for free tips and insights.
Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.