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Income Drawdown – understand the risks

Category: Pensions
Author: Leanne Macardle
Updated: 04/04/2017

The pension freedoms introduced in April 2015 give you plenty of options when it comes to turning your pot into a retirement income, and income drawdown is one of them. Since April 2015 you've had two types of drawdown to choose from, both of which have similar risks, but with some differences. These are:

  • Traditional drawdown
  • Taking regular payments direct from your pension fund

It's important to understand the potential drawbacks involved as well as the benefits, so below, we outline the key considerations to be aware of for each option.

Traditional drawdown

This involves you designating all or part of your pension fund as drawdown funds, which will allow you to withdraw the money (or "draw down" the pot) as you see fit. You can still take up to 25% of the fund as a tax-free cash lump sum, with any additional withdrawals being used as taxable income. The rest of the fund will remain intact and will continue to be invested in your chosen pension funds. There are no limits on how much you can take as income.

Risk 1 – Running out of money

The average retirement is longer than most people think, so that need for income could be for over 30 years. If you don't manage your income you could very easily run out of money from your pension pot, so it's important to carefully plan your annual drawdowns to ensure you don't spend it too soon. Exhausting your pot may be fine if you have income from other pensions or a full State Pension to fall back on, but if your pension pot is the basis for your main income in retirement, think carefully about taking too much too soon. Unlike with an annuity, drawdown doesn't guarantee you an income for life.

Risk 2 – Tax-free cash

In a traditional drawdown arrangement, you have to say at the outset how much of the fund you want to designate as drawdown funds, and crucially, how much you want to take as tax-free cash. If you don't, you'll lose the ability to take any cash tax-free, so you'll end up paying more tax than you need for the rest of your retirement.

Risk 3 – Investment performance

The funds that you designate for drawdown are still invested in your chosen funds, so any downturn in investment markets can result in your fund value going down. This means you will need to carefully select where your funds will be invested. Most people in drawdown choose to move their funds into lower-risk areas to avoid large fluctuations in their value.

Taking regular payments direct from your pension fund

The Government calls these payments 'Uncrystallised Fund Pension Lump Sums' (UFPLS). Essentially, it means taking cash directly from your pension pot and using it like a bank account. The first 25% of each payment is tax-free, with the rest being taxable as income.

As well as the risks of running out of money and poor investment performance (as with drawdown), there are some other specific risks with this type of arrangement.

Risk 1 – Losing out on tax-free cash

As each payment includes a tax-free element, not all of the available tax-free cash can be accessed up front. Most people like to access the full amount of tax-free cash at the outset, either to spend or to supplement their other income in a tax-efficient manner, something that this arrangement doesn't offer.

Risk 2 – Charges

However you choose to take your income, there will be some charges involved. Taking regular payments out of your fund is likely to be the most costly in terms of the fees and charges payable to the provider. These can eat into your retirement income, and could mean you run out of money sooner.

What next?

The pension flexibilities may offer retirees more options, but they've also made decision-making more complicated. It's important for people to think carefully before making any choices that they can't undo in the future, ideally by consulting the Government's Pension Wise Service, and by seeking independent financial advice.

Disclaimer: This information is intended solely to provide guidance and is not financial advice. Moneyfacts will not be liable for any loss arising from your use or reliance on this information. If you are in any doubt, Moneyfacts recommends you obtain independent financial advice.