How to avoid eight common mistakes in pension drawdown

What are the main SIPP drawdown risks for investors? Ceri Jones looks at ways to stop you walking a financial tightrope in retirement.

The pension freedoms introduced in 2015 have been well received, particularly by people in their 50's looking to take tax-free cash. But it is early days, and both consumer bodies and the financial services industry are concerned that many self-invested personal pensions (SIPPs) are being managed by people without much investment expertise, who are making poor decisions that could have dire consequences for them. Here is some advice on avoiding common mistakes that investors in drawdown often make.

1. Never invest your entire pension pot in cash

Between October 2015 and September 2017, nearly 350,000 people went into SIPP drawdown, and almost a third chose to manage their money without taking any financial advice. Worryingly, almost a third of these people are wholly invested in cash. Over the medium to long term, this means their funds will be eroded by inflation.

UK inflation is currently running at 2.5%, 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.

The Financial Conduct Authority (FCA) is thinking of banning SIPP holders from investing solely in cash, to deal with this problem. It reckons SIPP investors who are invested in cash could increase the income their pension fund generates by 37% by choosing a more appropriate mix of assets. It suggests an asset mix of 50% equities, 20% government bonds, 20% corporate bonds, 7% property and just 3% cash. As a rule of thumb, most people should have two years of their expected annual income in cash to avoid being a forced seller of investments.

What's more, in a drawdown plan you may have to pay charges for keeping your pot in cash. You could earn interest of just 0.5%, while charges on the pension fund could be 1%.

"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."

"Many self-investors hold excessive cash, which is eroded by inflation."

2. Don't resist reinventing your investment strategy

Many SIPP investors stay with familiar strategies and well-known funds that may have served them well in the accumulation stage of their pension plans, such as equity growth funds or old-fashioned equity market trackers. However, these have a lot of market exposure and can fall in value quickly in the event of a market crash, exposing investors to so-called sequence risk. This is where investors are forced to liquidate assets to take income when asset prices have fallen, eroding the capital available to generate 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% for tracker funds bought in 2000, when they could track the same index in a fund costing 0.06%."

For greater diversification, you can allocate to income-generating assets such as sovereign and corporate bonds diversified across different regions and to uncorrelated asset classes such as infrastructure, property, commodities and precious metals. Currently, emerging market debt and US Treasuries stand out as the best value in the bond market, although the former is a less predictable asset class.

Another alternative is absolute return funds such as Invesco Perpetual Global Targeted Returns and BlackRock UK Absolute Alpha, which aim to make a positive return regardless of the direction of the broad stockmarket.

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 making a transfer into a SIPP and moving into drawdown. One quarter of the amount you withdraw will usually be tax-free, while the rest will be taxable.

UFPLS allow simple and easy access to your money held in your pension fund and are good for people with smaller pension funds, as money not withdrawn will continue to be invested in a tax-efficient environment, while they will not be hit with the charges of transferring to another scheme.

If you're a basic-rate taxpayer, for example, taking an UFPLS every month - a quarter of which is tax-exempt – could save you from paying tax at a higher rate.

There may also be a marginal benefit in UFPLS in making the most of the lifetime allowance, because of the way the calculations are rounded, that could mount up over the years.

4. Be sure to avoid the 'emergency' tax trap

Some SIPP investors are being clobbered with high rates of income tax on withdrawals made from their pension pots. 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, which can take you into a higher tax bracket. For example, HMRC will charge income tax on an initial payment of £10,000 as if you were going to take income of £120,000 a year.

You then have to either wait for HMRC to pay the overpaid tax back or reclaim it. However, the reclaim process is rather time-consuming. There are three relevant forms: form P55 if you have taken a withdrawal but left money in your pension pot; form P53Z if you have emptied your pot but are still in employment; and P50Z for someone who has emptied their pot and is no longer in work.

The solution is to make a small withdrawal at the start of the tax year – £10 will do. This will trigger the emergency tax code. One month later you can take out the lump sum you want, knowing that your tax code, predicated on the earlier smaller payment, will be negligible.

Since the pension freedoms were introduced, tens of thousands of people have had to claim back hundreds of millions of pounds in overpaid tax. Although the government's Office of Tax Simplification has asked HMRC to look at the system, the HMRC has refused to change it.

5. Avoid triggering the money purchase allowance limit

It is easy for pension investors to inadvertently fall foul of a rule that severely restricts the amount they can contribute to their pension in future. This rule reduces their annual allowance from £40,000 to just £4,000 (including their employer's contribution). The reduced allowance is called the Money Purchase Annual Allowance (MPAA), and if you breach it a tax charge applies.

From age 55, most personal pensions allow you to take a quarter of your pension pot tax-free, with the rest subject to income tax. The reduced allowance is applied if you withdraw more than the 25% tax-free pension commencement lump sum. Taking even a penny of the taxable amount will reduce the annual allowance.

The MPAA does not apply if you are taking a small pots lump sum. Small pots, or trivial commutation in the jargon, are those that don't exceed £10,000, where a lump sum payment from the pot extinguishes all member benefits under the arrangement.

Up to three small non-occupational pensions such as personal pension plans can be commuted under small pots payment rules, and there is no limit on the number of occupational pensions that can be taken under these rules. 

6. Never overpay on pension provider charges

Small differences in the costs and charges you pay for investing your pension can make a big difference to the value of your pension over the long term, particularly as a pension in drawdown can run for 30 years or more.

The FCA recently identified 44 separate types of fee levied across the market, the implication being that it is hard to compare and contrast charges between different providers and products. The most expensive plans are four times as costly as the cheapest, with annual charges of around 1.6%, compared with 0.4% at the most cost-effective providers. See the September issue for a detailed comparison of SIPP charges.

The best SIPP for you will depend on the amount you have invested, the type of assets you invest in and how often you trade.

"The regulator says that switching your provider could increase your annual income by 13%."

7. Don't underestimate the trickiness of the SIPP rules

We expect our readers to be wise enough to avoid investing in unregulated investments, particularly those based overseas such as Ukrainian farming projects or carbon credits, but there are more mundane traps for investors to navigate. In particular, exotic assets – more correctly termed tangible movable assets (TMAs) – such as antiques, art, fine wines and classic cars are prohibited by SIPP rules.

The legislation, however, is a minefield, and HMRC can add or remove things from the list of TMAs at will. The most recent exclusion was investment- grade gold bullion.

Moreover, you need to be sure you are not loaning money to a third party such as a peer-to-peer lending organisation, which then invests the money in a prohibited asset. Residential property investment is also banned, including buy-to-lets, holiday lets and timeshares, even if they are run as businesses.

There are two exemptions regarding residential property. The first is if it is 'job-related': when the property is occupied by someone who is not connected to the scheme member and is used in connection with a business premise held in the scheme, such as a shop with a flat above that is leased to the trader using the shop.

A second exemption exists when the property is occupied by an employee who is not connected to the scheme member, where it is a condition of their employment that they occupy the property, as with a caretaker's flat.

Malcolm McLean, a senior consultant at Barnett Waddingham, warns:

"You could inadvertently break the rules by loaning money from the SIPP to a third party who, based on HMRC's wide-ranging definition of connected parties, is connected to the SIPP member, or by loaning money to an unconnected peer-to-peer lender that then invests the funds in TMAs such as fine wines."

8. Avoid taking excessive market risk by making big withdrawals

While taking too little risk in retirement is a poor strategy, making big withdrawals can also spell disaster for your long-term plans.

Investment shocks are by their nature hard to predict, but you need to take the possibility of falling markets into account when setting and reviewing your withdrawal strategy. If at all possible, it makes sense to simply cream off income and dividends, leaving the underlying assets intact.

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