Income drawdown: nine retirement dos and don’ts

We explain what you need to know about income drawdown and how to make the most of your pension pot.

Hard as it is to imagine today, before 2015 pension savers were not allowed to access their workplace defined contribution (DC) pension until the scheme’s normal retirement date (typically 65 for men). Even then they were forced to buy an annuity at retirement, which would provide a regular income until death.

Annuities were desperately poor value, compounded by the fact that most people bought the annuity product linked to their employer’s pension rather than scouring the marketplace for the best deal.

• Invest with ii: What is a SIPP? | ISA vs SIPP | Open a SIPP

The pension freedoms legislation, the brainchild of George Osborne when he was chancellor, allowed savers to flexibly access their defined contribution pensions from the age of 55, transfer their pensions out of final salary schemes into other authorised pension schemes such as a SIPP, and use the funds for a range of options, including cash withdrawal.

Initially, this prompted an outcry that people would squander their retirement savings, only to fall back on means-tested state benefits. The converse argument is that the money belongs to the saver. It should be the individual’s choice whether to be frugal or “spend the lot on a Lamborghini”, argued Lib Dem pensions minister Steve Webb.

In practice, savers behaved cautiously in the first years of the new freedoms, but in 2020 Covid struck, hotly followed by the cost-of-living crisis, and increasing numbers of over-50s have been taking more cash out of their pensions to make ends meet. Tax receipts from pensions rose to £1.7 billion for 2021-22, up from £0.4 billion in 2020-21, according to The Office for Budget Responsibility, which has also upwardly revised its forecast for pension tax receipts for 2022-23 by £0.8 billion.

So, what should investors do to manage their pension options wisely? Here are nine tips.

1) Watch out! Not all transfers from final salary pensions are foolhardy

Despite what you will have read, transfers from gold-plated final salary pension schemes are not always poor value for money. In fact, the employer’s pension scheme is legally bound to offer a transfer of the same value as the pension benefits given up. The trustees calculate this by measuring your benefits against gilt yields, so they can forecast the amount of money you would need now to generate an identical level of future benefits. They add in an extra amount for any other scheme benefits such as spousal pensions, dependants’ pensions and index-linking that may be forgone.

There are huge attractions to final salary schemes – primarily that they are guaranteed for life and you do not have to do anything but sit back and watch the income payments roll in. However, there may be good reasons to want to transfer. Perhaps you want to pursue a new business venture that requires capital or need to repay debt such as an outstanding mortgage. You may want to help children trying to get a foothold on the property ladder or contribute towards your grandchildren’s school fees. You may simply have enough money for retirement already, perhaps if your partner has a handsome guaranteed final salary pension.

• My pension dilemma: how much risk should I take in 2023?
• How downshifting career in your 50s could boost your pension by £89,000

Taking this course of action requires thought and consideration, and the government has made it a legal requirement to seek financial advice before you transfer from a final salary pension scheme.

2) Use the government’s advice schemes

If you’re over 50, you can book a free appointment to talk about your options with Pension Wise, a service provided by MoneyHelper. 

If you are under 50, you can still access MoneyHelper for free impartial help and information about your pensions.

• Dividend investing: three tips for a comfortable retirement income
• State pension age shock as big changes likely sooner than planned

3) Avoid triggering the money purchase annual allowance

You are allowed to invest £40,000 a year into your pension, but this drops to just £4,000 (including your employer's contribution), if you take out a penny more than your 25% tax-free entitlement. The reduced allowance is called the money purchase annual allowance (MPAA), and a tax charge applies if you breach it. You also lose the ability to carry forward up to three years of unused allowances in the current tax year.

The MPAA could unfortunately restrict your contributions to a pension at the very stage when you are earning the most in your career and have the capacity to invest more. To cap it all, you would have enjoyed higher employer contributions, which will then be lost forever.

• How to plan for a comfortable retirement
• Is the UK state pension really the worst in Europe?

4) Think about all your potential sources of income

For many people with ISAs and pensions, it may be more tax efficient to take money from ISAs first rather than your pension. ISAs are not taxed when you draw an income, so won't add to your tax bill if you're still working part time or have other taxable income.

It’s also important to consider your potential household income as a whole. For example, if one partner is constrained by the Annual or Lifetime Allowance in terms of contributions, it may be appropriate for the other partner to pay correspondingly higher contributions into a pension arrangement.

• Use ii's SIPP calculator here

5) Consider uncrystallised fund pension lump sums

You can draw lump sums directly from your pension from age 55 without making a transfer into a SIPP and moving into drawdown. This is called taking an uncrystallised fund pension lump sum (UFPLS). One quarter of the amount you withdraw will usually be tax-free, while the rest will be taxable.

UFPLS can be good for people with smaller pension funds, as money not withdrawn remains invested in a tax-efficient environment and avoids 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-free - could save you from paying tax at a higher rate.

You can only choose UFPLS if you've not already taken any tax-free cash or income from your fund.

• Five ways to maximise your pension income

6) Be scientific about how much income you take from your SIPP

As a rough rule of thumb, advisers often suggest you take no more than 3% or 4% income out of your pension pot per year, with the aim of not running out of money before your death. If at all possible, it makes sense to simply cream off income and dividends, leaving the underlying assets intact.

To get a better idea of how long you may live, complete an online mortality calculator, which may surprise you on the upside, but would then mean that you need to keep back more of your pension for a longer old age. If you are already middle aged, your life expectancy could be higher than the average life expectancy.

• Pension income drawdown: is the 4% rule dead?

7) Don’t forget inflation

It’s been estimated that one-ninth of people who take pension drawdown leave their entire assets in cash, thinking it is safe, but that runs the risk of erosion by inflation, particularly now that the cost of living is running high. Over the 20-odd years that constitutes retirement, inflation can wreak dreadful damage. At 11%, inflation would reduce the buying power of £1,000 to just £352 over 10 years.

Having said that, industry regulator the Financial Conduct Authority could soon demand that providers issue savers with a ‘cash warning’ if they hold more than 25% of their pension in cash for six months or more. The idea is to push them to consider investing in other assets to grow their pot as much as possible. But when markets are more volatile, as they are now, there’s a risk that a ‘warning’ might encourage investors to jump from cash into investments just before a market fall.

• Are these seven baby steps the secret to a wealthy retirement?

8) Don’t automatically take your 25% tax-free cash unless you have a purpose for it

“Lots of people take their cash and put it into a bank where it earns very little interest but is seen as ‘their’ money, while it could remain invested in a tax-efficient wrapper within the pension scheme if it’s not needed immediately,” says Rona Train, a partner at actuaries Hymans Robertson. “Also, when a pension is crystallised, people become subject to the Money Purchase Annual Allowance which limits the amount of pension contributions on which tax relief is available to £4,000 per annum. We’re already seeing people on relatively modest salaries being hit with significant tax bills due to being unaware of this restriction.”

• How does your pension compare with your neighbour?

9) Don’t fall for a scam

Many fraudsters are very convincing. They will typically try to sell you investments in exotic assets that are unregulated, such as farming and forestry overseas, or hotel apartments in far-flung places that may never be built. Some have names that sound uncannily similar to reputable financial companies. Common signs that someone is trying to defraud you are being contacted out of the blue, offered unrealistically high returns, time-limited ‘offers’, and fixed-term investments in the hope that you will not realise something is amiss for a few years.