Retirement is a significant milestone, marking the transition from a life of work to one of leisure and freedom.
However, managing your finances during this phase is crucial to ensure long-term security and comfort. Drawdown pensions offer flexibility and control, but they also come with potential pitfalls.
Remember: many pension schemes have an element of investment to them. As with any investment, your capital is at risk. The value of investments can fall as well as rise and you may not get back the amount originally invested.
Here are three common drawdown pension mistakes and how to avoid them.
1. Taking Too Much Pension Drawdown Income
The flexibility of drawdown pensions allows retirees to withdraw as much or as little as they want. However, this runs the risk of withdrawing too much income, which can drain the size of the overall pension pot at an unsustainable rate. This could mean potentially running out of money in retirement! This can be particularly problematic if the market underperforms or if you live longer than expected.
Things to think about when planning Pension Drawdown:
Plan Ahead: Work with a financial adviser to create a sustainable withdrawal plan. The commonly cited “4% rule” suggests withdrawing 4% of your portfolio each year, but this almost always needs adjustment based on your specific situation. You need to plan around your asset allocation, health, goals, and build in some resilience to market events during retirement. Your adviser will be able to help with this.
Regular Reviews: Revisit your withdrawal plan annually to account for changes in the market, inflation, and your personal circumstances. Ideally, you’ll be using cashflow forecasting and stochastic modelling with your financial adviser to review your pension at least annually. This is what we do at BlackBear, and we believe these tools form a robust retirement planning process.
Emergency Fund: Maintain an emergency fund to cover unexpected expenses without needing to dip into your retirement funds excessively.
Dipping into your pension for an emergency fund is often not desirable if you have no tax-free cash remaining, since you’ll end up paying tax at your marginal rate, as well as having to manage a “month 1” emergency tax payment!
2. Don’t make this mistake with your tax-free cash!
Many investors want access to their 25% tax-free cash as soon as they’re old enough to access their pension. This is typically referred to as a Pension Commencement Lump Sum (PCLS) for most drawdown contracts, although you’ll hear PCLS used for defined benefits schemes too.
We’ve seen investors attempt to access their tax-free cash without taking advice that end up taking Uncrystallised Funds Pension Lump Sum (UFPLS) payment thinking this is part of their 25% tax-free lump sum.
My taking a withdrawal from a pension in the form of an UFPLS, 75% of the payment is not from the 25% proportion of the pension pot that is tax-free – meaning that the investor has inadvertently triggered the Money Purchase Annual Allowance rules.
This significantly reduces the amount they can contribute to your pension and still receive tax relief and is a disaster for anyone still working after accessing their pension.
Don’t make these Pension Drawdown mistakes:
Understand the Difference: Recognise the distinction between a PCLS and UFPLS. PCLS allows you to take 25% of your pension pot tax-free without triggering the MPAA, whereas UFPLS can inadvertently activate these restrictions.
Seek Advice: Consult with a pension advisor before making any withdrawals to ensure you’re accessing your 25% tax-free cash correctly and not triggering unintended consequences.
Stay Informed: Keep yourself updated on pension rules and regulations to avoid inadvertently triggering the MPAA and limiting your future pension contributions.
By understanding the implications of different withdrawal methods and seeking appropriate advice, you can ensure you access your tax-free cash without unintended penalties.
3. Not taking a risk-managed approach to Pension Drawdown
Asset allocation is crucial in managing risk in your pension portfolio. However, many retirees either take on too much risk by remaining heavily invested in equities or become too conservative, which can hinder growth and fail to keep pace with inflation.
As you approach a targeted retirement age, your financial adviser should set you on a “glide path” in line with your goals, needs, attitude to risk, and capacity for risk. This means changing your exposure to different asset classes over time to manage volatility appropriately during the 10 years prior to retiring.
A smart approach to risk-management in your pension:
Balanced Portfolio: Diversify your investments across various asset classes, including equities, bonds, and cash assets. This helps manage risk while providing opportunities for growth.
Regular Rebalancing: Periodic reviews and adjustments to your asset allocation can ensure it remains aligned with your risk tolerance, investment goals, and market conditions.
Professional Guidance: Consider working with a financial planner who can help tailor an asset allocation strategy to your specific needs and circumstances.
BONUS TIP: Have you nominated any beneficiaries?
If you haven't set up an expression of wish for your pension, the trustees of the scheme might not pay out your pension in line with your preferences on your death. You can learn more about this here.
Pensions are complex – so plan properly!
Drawdown pensions provide the flexibility and control many retirees desire, but they also require careful management. By avoiding these common pitfalls — unsustainable income withdrawals, inadvertently triggering the MPAA through a UFPLS, and improper asset allocation — you can help ensure that your retirement years are financially secure and enjoyable.
NEED MORE HELP WITH PENSION DRAWDOWN?
We believe the best strategy for retirement is to get help from an Independent Financial Adviser that you trust.
We’re pension experts local to Cheshire and the North West England – so just reach out if you’re unsure on how to plan your retirement.
You can get in touch with us directly by clicking the link below.
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