Pension freedoms which came into force in April last year removed the near-requirement to buy an annuity upon retirement, and were welcomed by many investors.
According to data from trade body the Association of British Insurers (ABI), many people have turned to flexible income drawdown retirement products since then, with £1.48bn invested into drawdown during the first quarter of 2016.
These policies are so named because your money remains invested while you draw down a portion of the income.
But a statement from the ABI also warned: “There are signs a minority may be withdrawing too much too soon, and at rates that would see their money run out in a decade or less”.
Before heading into drawdown, how can you avoid becoming part of that minority? Here are six questions that qualified advisers and pension experts believe are important to ask.
Steven Cameron, pensions director for Aegon, believes this is the “headline question” to ask from about age 50 onwards, or five years before you are planning to take income.
He says: “If you want to keep working, then going into drawdown does not mean you have to take an income — you can leave it invested, in which case you and your adviser should review the investment strategy so you are investing in line with your plans for retirement.”
Martin Bamford, chartered financial planner for Informed Choice, phrases the question differently: “What rate of withdrawal can my pension pot sustain without a significant risk of running out of money in my lifetime?”
You should review regularly how much income you are taking. Are you depleting your funds too quickly? Mr Bamford comments: “Conventional wisdom suggests a safe withdrawal rate of approximately 4 per cent a year, although the most suitable withdrawal rate will depend on a variety of factors, including tolerance and capacity for risk, health and chosen investment portfolio.”
According to Colin Parkin, managing director of Ample Financial Services, many people intend to fully retire when they reach state pension age of 67, but want to take their workplace pension at 60 as they start to wind down.
While you may be considering doing this, and funding the remaining seven years through drawdown, this could actually be less tax efficient than if you were to refrain from withdrawing money.
Mr Parkin explains: “If you take cash out of your pension pot using drawdown while working, your earnings could push you up into a higher rate tax bracket.”
For example, if you have a £100,000 pot, and encash £10,000 in the first year, you can get £2,500 tax-free cash and £7,500 income, which will be taxed at a marginal rate. But if you are earning on top of this, you could find yourself taxed as a higher rate taxpayer.
Even if you draw down the bare minimum each year, you could still be pushed up into the 40p tax bracket because of other forms of income, such as the state pension.
Mr Bamford believes all investors should monitor and review their drawdown withdrawal at least once a year.
David Trenner, technical director for Intelligent Pensions, says: “Withdrawal risk is essentially taking too much from your plan and running out of money. Your adviser can show you when, subject to the modelling assumptions, your fund would run out at the level of income being taken.
“While being too aggressive with withdrawals is a common problem, we have also seen people being overly prudent and taking too little income, thereby compromising their standard of living.”
This is the most important question for David Penney, director of chartered financial planners Penney, Ruddy & Winter. He explains: “The decision-making process for choosing the right strategy at retirement has not fundamentally changed since pension freedoms were introduced.
“The fact that there are more options does not change the fact drawdown is still inherently risky, with the risk being that you could suffer a reduction in income.”
According to Mr Penney, if the investment strategy does not produce a sufficient return to support the income withdrawals, and the capital is eroded, there has to be an alternative option.
He adds: “You either need to stop or reduce withdrawals, and fund outgoings from savings, or you need to sell assets. If someone has a home, a pension fund and not much else, drawdown is invariably unsuitable.”
Billy Burrows, founder of consultancy Retirement Intelligence, calls this the million dollar question, adding: “Everything else is a side-show”.
This is because of sequence risk (or “sequence of returns risk”) relating to the investment performance of the pension pot immediately after retirement.
If the underlying investments suffer heavy losses in the first few years of retirement, this will significantly affect your ability to fund your later years.
Mr Burrows explains: “At 40, if you lose 10 per cent of the fund through market movements, you have time to recover. If you are already drawing 4 per cent to 5 per cent from the fund and the market moves against you, then you don’t have time to make it up.”
He believes it is important in retirement not to try to shoot the lights out in terms of performance. “You should be looking to protect on the downside”.
Mr Trenner adds: “Holding adequate cash and defensive assets to meet income and cash payments in the short to medium term is an important ongoing aspect of drawdown management.”
Mr Cameron says when you leave work, your investment plan may default into gilts and cash, which is not good for growth potential. However, if you decide to go into drawdown, you can remain in higher-performing funds for longer — providing this is in line with your objectives.
Adrian Walker, retirement planning expert for Old Mutual Wealth, advises: “In your 40s and 50s, an adviser can project what kind of retirement savings pot you will need and give you an idea of how much more to save based on different market conditions.
“If you’ve got a shortfall in your projected retirement savings, an adviser can recommend how to maximise your savings capacity by finding the right investment approach.”
OK, that’s three questions in one, but this is “really worth emphasising”, says Mr Burrows.
Mr Parkin agrees. “People need to understand what they want to do when they retire and how they are going to fund it.
“If you are thinking of retiring at 60, then you will need more money between 60 and 70 than you will between 80 and 90, so it is important to have a plan.”
Mr Walker adds: “The best retirement planning starts well before you actually retire. Once you’ve established when you aim to retire and what you want to achieve, your adviser can help you plan towards those goals.”