Five risks of income drawdown and how to combat them

If you’ve got a personal pension, what you do with it when you retire is totally up to you. You can even start taking money out before you retire, if you wish, so long as you’re age 55 or older (rising to 57 in 2028).

For many retirees flexi-access drawdown looks like the perfect solution; you can withdraw however much you like, whenever you like. Or, if you don’t need the income yet, you can take your tax-free cash, and leave the money until you do.

• Learn more: SIPP Drawdown | SIPP Withdrawal Rules | Open a SIPP

And, as your pot remains invested, there’s also the potential for further growth. This can provide you with a helpful hedge against inflation - helping you manage rising costs as your retirement progresses.

A further attraction, for many people, is that when you die any money that’s left over can be passed onto your loved ones, although there might be some tax to pay, depending on your age on death, who inherits the pot, and whether you pass before or after April 2027.

These attributes go a long way in explaining why new retirees are favouring drawdown over less-flexible annuities, a type of insurance policy that pays a fixed income for life but doesn’t typically return unspent funds when you die. In fact, in the first quarter of 2024 (the latest Financial Conduct Authority (FCA) figures available) drawdown trumped annuity sales by more than three to one.

However, while income drawdown gives you total control of your retirement finances, it’s not a risk-free strategy.

Ian Cook, chartered financial planner at Quilter Cheviot explains: “Drawdown offers flexibility, but with that freedom comes responsibility. Unlike an annuity, where income is guaranteed for life, drawdown places the onus on the individual to ensure their pension pot lasts. That means keeping a close eye on a range of risks that can quietly erode retirement security if left unchecked.”

With that in mind, we look at five risks that drawdown investors face, plus tips on how to beat them.

1. Stock market volatility

Investing in the stock market isn’t always a smooth ride and the big worry for many retired investors is the impact a downturn could have on their pot. “Drawdown typically means staying invested, and while that can help deliver long-term growth, it also exposes you to the ups and downs of the market. A sharp fall early in retirement can be particularly damaging, especially if you're making regular withdrawals,” warns Cook.

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This is referred to as ‘sequencing risk’ and it means that if you keep taking money out of your pension while share prices are falling, your losses will be compounded. However, it is possible to protect your pension by keeping a healthy cash buffer that you can draw on instead of selling shares during periods of stock market volatility. This will relieve the pressure on your pension and give your investments the breathing space they need to recover. Another option, adds Cook, “is to use more conservative funds for near term income, so you’re not forced to sell investments at the wrong time.”

2. Inflation

Retirees should ignore inflation at their peril, and a key part of any retirement income plan should be how you’ll cope with rising prices over time.

Take £2,000 today. Even if inflation was in line with the 2% Bank of England target, in 10 years’ time it would only be worth £1,641 in today’s money, or £1,346 after 20 years.

“Inflation may not feel like an immediate threat when you first retire,” notes Cook, “but over a 20- or 30-year retirement, even modest price rises can significantly erode the spending power of your pension. That £2,000 monthly income today might feel comfortable, but it could fall short of your needs later in life if prices rise and your withdrawals don’t keep pace.”

This means investing in retirement needs to be a balancing act. While the threat of stock market volatility might mean you shouldn’t invest like a 30-year-old, it’s also important not to take your foot off the growth pedal altogether. “Ensuring your investments retain some growth potential, even in retirement, can help your pot keep pace with inflation,” he adds.

3. Overspending

The beauty of income drawdown is that you can take as much out of your pension as you want, when you want. But it doesn’t necessarily follow that you should. Selling investments to fund a special holiday or to pay for home improvements for example, could put a significant dent in your pot and reduce its ability to generate income in the future.

“The danger is that people anchor their withdrawals to their current lifestyle or the 25% tax-free cash, rather than what’s sustainable,” says Cook.

There are a number of strategies you can employ to ensure you don’t spend your pension too fast. The ‘4% rule’, for example involves taking 4% of your pension’s value during the first year of retirement. Each year afterwards, you take the same amount plus inflation.

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Whatever the market does, the theory goes that your pot should last approximately 30 years. This clearly isn’t guaranteed, and if investment conditions are poor, be mindful that your pot could drain sooner.

Another cautious approach is to limit yourself to only taking the ‘natural yield’ of your pension – that means you live off your investment returns and leave your capital untouched.

Alternatively, you might want to seek the advice of a financial planner who will be able to use cashflow modelling to help you work out what impact different rates of withdrawal will have on the sustainability of your pot across a variety of different scenarios.

• Work out how long your pot is likely to last with our drawdown calculator.

4. Living too long

Overspending is tightly linked to another risk - living for longer than you expect.

When you’re working out how much you can afford to spend, you also need to give careful attention to how long you’re likely to live.

Numerous studies have shown that people tend to underestimate how long they will live – often thinking they won’t live longer than their parents did.

It is, of course, impossible to know how long you’ll live, but you’ll reduce the risk of outliving your pension if you do a bit of research and err on the side of caution.

The Office for National Statistics’ (ONS) life expectancy calculator, for example, shows that a 66-year-old man can currently expect to live until age 85 but there is a one in four chance he will live to 92 and a one in 10 chance of reaching the age of 96.

There’s even greater pressure on women’s pots. A woman of the same age has a typical life expectancy of 88 years. There’s a one in four chance she’ll live to age 94 and one in 10 chance she’ll make it to the ripe old age of 98.

Only once you’ve considered how long your pot needs to last, should you make any decisions about how much you can afford to withdraw.

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It’s also worth noting that if you start to worry more about the sustainability of your pot as your retirement progresses, you don’t need to stay in drawdown.

You can convert your pot into an annuity at any stage – either in one go or in tranches.

As you get older, you are likely to get better value from an annuity, especially if you have developed any health conditions that could mean you benefit from an enhanced rate.

5. Changing pension rules

Over the last decade or so we’ve seen huge amounts of change in the world of pensions. Some good like the Pension Freedoms and the abolition of the lifetime allowance, some bad such as pensions becoming subject to inheritance tax (IHT).

This means it’s vital you don’t accept the status quo and make a commitment to stay informed – especially if you don’t have an adviser to keep you up to speed.

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Cook says: “Pensions policy in the UK is no stranger to change, and while the rules currently allow drawdown flexibility and tax advantages, future governments could alter the landscape. For example, pensions will likely soon become liable to IHT. This might influence the direction of your financial plan if IHT is something you are worried about.”