Historically pension savers provided themselves with an income in retirement by using their pension funds to buy an annuity. The advantage of annuities is that the payments are guaranteed for life of the annuitant. If an annuity is bought whilst annuity rates are high then a commensurately high income can be obtained. The disadvantages of annuities are numerous however, especially now that interest rates are minimal. Once an annuity is bought the buyer loses access to the capital used to buy the annuity. If the annuity is bought when annuity rates are poor or fund values are depressed by recent market falls then the annuitant is effectively locked into a low rate for life. The fund is lost on death because excepting any guarantees that have been purchased, payments cease with the death of the annuitant. Similarly, if a spouse’s annuity is bought and he or she dies first then that cost is effectively wasted. For all of the above reasons and owing to the much greater flexibility it affords, drawdown is now overwhelmingly the choice of the vast majority of retiring clients for whom we have developed our advised dynamic drawdown solution.
Individual Drawdown Solutions Tailored Personally for Every Client
We have identified eight different drawdown client types, though some clients are ‘cross-category’ and some move from that in which they started out. We examine these below.
Deferred Drawdown (tax-free cash only for now)
Some clients come to us just wanting to take out their tax-free cash, often to pay off debts, or to endow a son or daughter with money for a deposit against a mortgage to buy their first house. They may have an idea about whether they want an annuity or drawdown long-term, or they may have formed no such opinion. These, for us, are straightforward investment cases. We take the money from a plan that can’t facilitate what they want and we move it to one that can. Thereafter we manage the pot of money, aiming to grow it as much as possible until such time as they do want to use it to provide a regular income, perhaps cross-funding ISAs. When that moment arrives, then we can have the annuity versus drawdown conversation, and advise them appropriately.
Annuity Substitute Drawdown
These clients ideally need a secure income for life over and above that which their state retirement pension and savings are likely to provide, but for whatever reason, they have a serious aversion to annuities. Maybe they don’t expect to live that long, regardless of generally-increased longevity in the last 30-years, and/or they have an inbuilt aversion to an annuity company making a mortality profit off them. Maybe they’ve decided annuity rates are awful and feel insulted by the fact that they’ll get so little back. It’s understandable; a 65-year-old male who, statistically speaking, is likely to die around age 87, gets less than 5% on a standard annuity rate these days. That means he has to live at least 20 years – to age 85 – to get his own money back, not counting the effect of inflation and disregarding the Income Tax take. In real terms it’s statistically unlikely that he’ll ever get his own money back, never mind making a profit on the investment that his pension-fund / annuity-purchase-price represents.
Small-Pot Strip-down Drawdown
At the ‘small-pot’ end of the scale clients often have good occupational pensions as well as their small fund. Some have defined benefit entitlements but their employment ended or their employers closed the defined benefit scheme and provided a defined contribution replacement. Some want to retire early and to bridge the gap until their state retirement pension and/or occupational pensions kick in. These clients, as well as being ‘strip-down’ clients, also fall into the ‘gap-fill’ category explained below. Some though are just plain poor; people who for most of their lives had no pensions at all, but who at some time worked for an employer who provided one for a short time, hence the small pot. Whichever, they’ve decided, understandably, that £20,000 or £30,000 is more use to them as a one-off lump sum than as an annuity of maybe £20 or £30 per week for life. Many such people hit retirement with debts still outstanding. The income freed-up, and peace-of-mind achieved by clearing debts, makes cashing their pension plans worth it for them. With these clients, we generally find ourselves staging the strip-down over maybe two or three tax years, to keep them under their personal allowance, thus helping them get all the money out of their pension tax-free.
Large-Pot Strip-down Drawdown
At the ‘large-pot’ end of the strip-down category are the clients who hated forced annuitisation and were delighted by the advent of flexible drawdown. The problem is that they fear a change in government policy reintroducing forced annuitisation. They have a fixation on getting all the money out immediately, “so I know it’s mine”. Often their only plan is to put the money in the bank. We explain that “it’s still theirs” in the pension pot, it’s more tax efficient to keep it there until they actually need it, and that drawing it all in one go is tax inefficient. We explain that by drawing down in a more sensible and structured way, they can avoid higher rate tax. Most see sense, calm down and stay in drawdown long term, but some still strip their funds down as fast as they can without breaching the higher rate threshold. It is their prerogative. Chancellor George Osborne gave them the right. We’re the client’s servant and adviser, not their master. We try to educate them to the reality, that no government is likely to reintroduce forced annuitisation, but we can’t guarantee they won’t as they’re the legislators not us. Thus, we try to minimise the tax damage.
Gap-fill drawdown clients typically want to retire early and to bridge the income gap until their occupational and/or state pensions kick in. They might be stripping down an entire small pot, or alternatively just taking more from a larger fund now, to give them the income they need, and planning to take less later on once their other pensions come on stream. Where clients have personal allowance ‘headroom’ we typically cross-fund into ISAs to minimise their long-term Income Tax liabilities, as ISA income, unlike pension income, is tax-free.
‘Live it up’ drawdown clients will typically come to us with a small-to-medium sized pension pot saying “I’m 65 and I want 10 or 15 good years out of it. I’m not in great health and I doubt I’ll be doing foreign holidays that much longer. I want to enjoy my money while I’m still fit enough. After that I’ll live on my old-age pension.” Annuity companies, we know from the high-level discussions in which we’ve been involved (a meeting at the ABI which included representatives from the Treasury) don’t like to admit either that such people exist, or that anyone can live on the state retirement pension alone. (It’s bad for annuity sales!) The reality however is that such people do exist; we operate in a poor town where many elderly people are living on the state retirement pension alone. We’ve had family members who’ve grown old on the OAP. Another typical sentiment is “I don’t want forty quid a week from an annuity just going to pay nursing home fees when I’m 90. I want to have a good standard of living early in my retirement, not a little bit of money every month forever, that’s worth less and less with inflation.” These are phrases actual clients have used to us. Many clients. Repeatedly. This is real life. We deal with it. If they stay healthier longer than expected however, then equity release might also be an option for them.
Inheritance Planning Drawdown
These are clients who have significant wealth and a likely Inheritance Tax liability, whose pension fund forms just one part of it. Their intention is to leave their fund untouched so far as is reasonably possible, because they rightly see its preservation as being a good way for them to pass on wealth Inheritance Tax free.
In this seventh category are clients who have occupational and state pensions that more than meet their income requirements, but who have a defined contribution ‘pot’ as well that is figuratively speaking for them, the ‘cream on the cake’. Maybe they’ll want to take ad-hoc lump sums for special holidays or to help their children fund house deposits. Maybe it’ll end up being passed on as inherited wealth. Pension freedoms are perfect for such people because, unlike the days of forced annuitisation, they really do have the flexibility they need to make the best use of their accumulated pension wealth for themselves and their families.
Drawdown Risks and Realities
Asset prices – shares, bonds, and property values – have historically increased in value over the longer term, but markets do fall from time to time. Sometimes markets fall suddenly and heavily as in 1987. Sometimes they fall more gradually over a longer period. Markets can be highly volatile as happened in 2008, when we often saw 10% in-day swings. Some advisers blandish clients that somehow, “it’ll all work out fine”. Others lead their clients to believe that they can somehow immunise them from market falls, lulling them into a false sense of security. The fact is that no adviser can immunise clients from market falls, and that includes us. We can however build a drawdown portfolio in such a way as to reduce its vulnerability to market volatility.
Drawdown, naturally, works best in a rising market as progressively less shares need to be sold to fund each successive income payment. Drawing down from a volatile fund however can lead to faster erosion of your pension fund as regular withdrawals may be taken when the price has dipped. The large in-day swings we saw in share prices during 2008 would likely have wreaked havoc on portfolios where regular withdrawals were being taken from equity funds. ‘Sequence of return risk’ is also a problem. This refers to the specific risk that share prices may fall heavily early on in the drawdown exercise forcing the sale of a disproportionate number of shares to meet an income need and thus disproportionately reducing the future growth potential of the remaining fund.
We reduce sequence of return risk by programming our drawdown arrangements to take income withdrawals from less-volatile funds and start by reserving up to 24 months’ income in such funds. We call this the ‘in-plan buffer’, as distinct from the client’s non-plan self-managed cash buffer fund. Then, periodically, we internally review the portfolio and advise the client on replenishing the in-plan buffer from the other funds in the portfolio. The aim is to replenish is using money from the funds we would rather downsize whilst preserving the holdings we believe have greater potential. Where market falls are heavy, general and sustained, as happened in 1987 and 2008 for example, we may also advise clients to draw on their own self-managed ‘non-plan’ cash buffer funds, again to avoid the unnecessary depletion of their holdings. (We always advise all clients, especially drawdown clients, to keep a good-sized self-managed cash buffer fund.)
We cannot manufacture gains when markets are falling, nobody can; but by judiciously managing how your drawdown is provided, we can aim to minimise the impact of falls when they do happen, and maximise the benefit of recoveries.
Overall Strategy and the Order of Drawdown
The over-arching objectives we aim to achieve for drawdown clients are –
- Providing the amount of retirement income which you require when you need it;
- Income Tax deferral until you absolutely have to pay it;
- Income Tax minimisation when you have to pay it;
- Inheritance Tax mitigation as a by-product of the above.
When a client needing a retirement income has significant cash, pension, ISA and non-ISA funds it’s important to get the drawdown in the optimal order. The means by which we achieve the required drawdown will usually involve some or all of the following –
- Taking the tax-free cash and an occupational pension from any relevant scheme of which the client is a member. How much tax-free cash is taken, within minimum and maximum limits, depends on each given client’s circumstances;
- Keeping a sufficient cash buffer (self-managed by the client) from which income payments can be taken if we have a ‘crash’ like 1987 or 2008;
- Using excess cash to fund stocks-and-shares ISAs each tax year that can provide tax-free income and capital gains, and possibly also to fund non-ISA investment portfolios so as to generate dividends that can be taken tax-free using the dividend allowance;
- Taking ‘income’ by way of realised capital gains on non-pension non-ISA investment funds so as to utilise the CGT exemption and reduce the likelihood of a CGT liability in the future;
- Taking natural income from ISA funds tax-free, and from non-ISA dividends within the dividend allowance;
- Taking capital withdrawals from ISA funds tax-free;
- Taking pension tax-free cash, either on its own, by way of phased drawdown or by way of UFPLS, an uncrystallised funds pension lump sum, which is a payment that can be made from any part of a pension fund not previously accessed. Each UFPLS lump sum has a 25% tax free portion, with the remaining 75% subject to income tax;
- Taking potentially taxable pension income from money-purchase defined contribution pension funds;
- Cross-funding from defined contribution pensions to ISAs so as to utilise the full annual personal allowance and minimise overall long-term Income Tax liabilities;
- Funding defined contribution pensions, possibly right up to age 75, using the £3600pa gross contribution allowance so as to collect tax relief as ‘instant guaranteed growth’.
Most of the above is self-explanatory but it’s worth zooming in below on a few aspects where the reasoning might be less obvious. Usually, we’ll want a client to take their occupational pension at their normal retirement age because ‘missed years’ of income take years to make up. Self-managed cash-buffer wise, we ideally like a client to have the equivalent of at least a year’s worth of income on deposit, better still two years. Beyond that it’s up for discussion how much extra cash a client keeps. For the very cautious we’re happy for them keep larger deposits, less for the less risk averse. As the exercise progresses, we keep an eye on any capital gains that are not within the ‘wrapper’ of a pension or ISA. Realised gains can be siphoned off by the client for additional ‘income’ or recycled via modern-style (and therefore perfectly legal) ‘Bed & Breakfasting’ and/or ‘Bed and ISAing’ exercises. ISAs can produce tax-free natural income and capital withdrawals. Ideally, we like to keep defined contribution pension funds untouched as long as possible, so long as that won’t result in any unnecessary tax payments being generated by what’s going on in the rest of a client’s portfolio. The first reason we plan in this way is because, all things being equal, defined contribution pension funds should grow more the longer they are left uncrystallised, meaning that at the point they are crystallised the tax-free cash should, all things being equal, be greater than it would otherwise have been. There is a caveat here though; obviously we won’t defer it if, for example, it means a valuable guaranteed annuity rate with a deadline would be lost. If ‘spare’ cash is available, we may well advise continuing to pay into a defined contribution pension arrangement post-retirement using the maximum £3600pa gross (£2880 net) allowance for persons with no pensionable income. The idea is to grow the fund as much as possible with the assistance of tax relief and within a tax-free environment so as to maximise the tax-free cash and the amount protected from Inheritance Tax. There is no ‘one-size-fits-all’ answer. That’s why we developed ‘It all ADDS up’, to offer each client a personally tailored retirement income plan that takes into account their retirement income needs in the immediate, medium and long-term, their attitude to risk, and their overall Income Tax, Capital Gains Tax and Inheritance Tax situation. Touching on Inheritance Tax brings us to the second reason why, ideally, defined contribution pension funds are last in the queue to be tapped for drawdown. Defined contribution pension funds are held under trust and outside your estate and so don’t form part of your estate for Inheritance Tax purposes. That makes pensions potentially a very effective Inheritance Tax planning tool for clients who might have an Inheritance Tax problem.
That’s our Advised Dynamic Drawdown Solution – It all ADDS up, our tailored solution for drawdown clients, individually tailor-made and dynamically managed for every single one.