Eight pension drawdown dos and don’ts
What are the main SIPP drawdown risks for investors? We outline strategies to stop you walking a financial tightrope in retirement!
Reading time: 15 mins
Pension freedoms introduced in 2015 were well received, especially by those aged 50+ wishing to unlock tax-free cash. However, the financial services industry and consumer groups are worried that many self-invested personal pensions (SIPPs) are being managed by people lacking in investment expertise, making ill-informed decisions with potentially disastrous consequences.
Below are some tips on how to avoid some of the common mistakes that investors who are in drawdown often make.
1. Never invest your entire pension pot in cash
In the period between October 2015 and September 2017, nearly 350,000 people went into SIPP drawdown, with almost a third choosing to manage this process without taking any financial advice. Of additional concern is that nearly a third of those wholly invested in cash. Over the medium to long term, the result is that their funds will be eroded by inflation.
UK inflation is currently running at 2.1%, although it is likely to edge higher. But inflation and compounding are a dangerous mix. If inflation were to average 2% a year over 10 years, £1,000 would be worth just £800 at the end of the period, while inflation at 5% would reduce the real value of a pot to £550 over the decade.
To deal with this problem, the Financial Conduct Authority (FCA) is considering banning SIPP investors from investing solely in cash. It argues those SIPP investors could increase the income their pension fund generates by 37% by choosing a more suitable asset mix. It suggests an asset mix of 50% equities, 20% Government Bonds, 20% in Corporate Bonds, with 7% in Property and as little as 3% as cash. As a rule of thumb, most investors should have two years of their expected annual income in cash to avoid having to sell their investments in times of financial hardship.
You should also beware that you may have to pay charges for keeping your pot in cash in a drawdown plan. It is not unheard of to be faced with charges of 1% whilst the interest earned is just 0.5%
‘A wide range of investments are permitted in a SIPP, but many self-investors hold excessively large amounts in cash in the belief that it is the securest investment, even over the long term,’ says Nick Dixon, investment director at Aegon. “Over a period of five or more years, cash is typically eroded by inflation, so investors should instead look to other asset classes such as equities for higher returns.”
He adds: “Where equity funds are held, often the best approach is long-term patience to ride out the highs and lows of markets. However, when markets have already surged upwards, many investors jump on the bandwagon, not wanting to lose out, and acquire assets when market confidence and asset prices are inflated. During times of intense volatility and when markets plunge, there is a tendency for self-investors to panic and sell-out, giving up hope of strong returns.”
2. Don’t resist reinventing your investment strategy
A mistake many SIPP investors make is sticking with the well-known funds that have served them well in building up their retirement pot, such as equity market trackers or equity growth funds. However, these are exposed to the vagaries of the market and in the event of a crash can quickly fall in value forcing investors to liquidate assets to take income when asset prices have fallen, diminishing the available capital to create future income.
Experts stress the need for wider diversification and monitoring of portfolios, and say investors should resist being buffeted by short-term noise. Dixon says: “A lack of confidence contributes to inertia among self-investors, with many remaining invested in expensive funds even when cheaper alternatives are available. Some investors are still paying 1 per cent for tracker funds bought in 2000, when they could track the same index in a fund costing 0.06 per cent.”
3. Consider uncrystallised fund pension lump sums
The pension strategy of taking an uncrystallised fund pension lump sum (UFPLS) allows you to draw lump sums directly from your pension from age 55, without the need to transfer into a SIPP and moving into drawdown. 25% of the amount drawn is normally tax-free, whilst you would pay tax at the appropriate rate on any further withdrawals.
UFPLS enable easy and simple access to the money held in your pension fund and are particularly suitable for those with smaller pension pots because any money not withdrawn continues to be invested in a tax-efficient environment and they do not incur the charge of transferring to another scheme.
For example, a basic-rate taxpayer taking a monthly UFPLS – 25% of which is tax-exempt – could save paying higher-rate tax.
Also, there could be some benefit in UFPLS by making the most of the lifetime allowance as the calculations are rounded which over the years can mount up.
4. Be sure to avoid the “emergency” tax trap
You need to understand that some SIPP investors have been hit with high rates of income tax on the withdrawals they make from their pension fund. This is because HMRC applies an “emergency” tax on the first withdrawal of each new tax year and assesses it as if it is the first of regular monthly payments to be paid over the year. The result is that takes people into a higher tax bracket e.g. HMRC will charge income tax on an initial payment of say £15,000 as if you were going to draw income of £180,000 a year.
You are then faced with the choice of waiting for HMRC to repay the overpayment of the tax or reclaim it. Whilst it is a case of filing the appropriate paperwork, it is somewhat time-consuming.
There is quite an easy solution and that is to make a small withdrawal at the beginning of the tax year – as little as £10. That triggers the emergency tax code and the following month you can draw the lump sum you want knowing that your tax code, established on the previous smaller payment, will be insignificant.
Since the pension freedoms were introduced, tens of thousands of people have had to claim back hundreds of millions of pounds in over paid tax. Whilst the Government’s Office of Tax Simplification has asked HMRC to look at the system, they have so far refused to change it.