Three years of pension freedoms
April marks the third anniversary of the introduction of pension freedoms, which allow investors aged 55 and over to take money out of their pensions as and when they want to.
Prior to the introduction of these rules, the vast majority of investors used their pension to buy an annuity, or income for life.
According to latest date from the city regulator the Financial Conduct Authority (FCA), only just over one in 10 pension pots (12%) are now being used to buy an annuity, whilst almost 700,000 retirees have opted for drawdown. Currently around £101 billion is in drawdown, with an average fund value of £148,750.
Steve Cameron, pensions director at insurer Aegon said: “Looking at typical investment returns over the last three years, people taking the average income of 5.2%, look to have done well and may find even after taking a substantial income, they have more in their pot than when they started.
However, retirement can last 20 or even 30 years and prospects in drawdown change depending on how much income is taken as well as on investment returns which can change dramatically year on year.”
What to watch out for
If you’re considering using drawdown, it’s important to understand the risks involved, as well as the benefits.
Danny Cox, of independent financial advisers Hargreaves Lansdown said: “For the right people pension drawdown provides retirees with much greater flexibility on how and when income is drawn, compared to an annuity. Drawdown is also more flexible on death and, with the right investment choices, can see higher incomes drawn over the pensioners lifetime.
“In a drawdown plan, the pension fund remains invested. This means it comes with risk, the main one being that the investments don’t do well enough to sustain the income being taken. In short, you could run out of money in the future.”
Taking out too much also means you risk a potentially hefty tax bill. You can only take up to 25% of your pension as tax-free cash. If you withdraw more than this, these withdrawals will be taxed as income, payable at your highest rate, so the more you take out, the more tax you’ll pay. You may therefore decide to draw an income from your pension more gradually to keep your tax bills to a minimum, or you might want to use some of it to buy an annuity.
Mr Cox said: “An annuity guarantees the pension income for life and suits those who are risk averse and want to know their pension is guaranteed.”
If you’re not sure how much income to draw from your pension, or whether buying an annuity is the right option for you, seek professional financial advice.