The key trends a decade on from pension freedoms

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Having recently passed the first 10 years of pension freedoms, Kyle is joined by friend of the pod Craig Rickman to discuss how pension savers have been taking advantage. The duo explain how income drawdown, where you remain invested and take money out whenever you please, has become the retirement income strategy of choice. Craig also talks through pension withdrawal rates, as well as the episode covering the 4% rule and benefits of taking the natural yield from a portfolio.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to On the Money, a weekly look how to get the best out of your savings and investments. In this episode, we're looking at the key trends that have emerged in the first decade of the pension freedoms. Joining me to cover this topic is Craig Rickman, personal finance editor at interactive investor. Craig, let's firstly go back in time eleven years ago, as it took a year for the pension freedoms to then be implemented. Where were you during that Budget when (Chancellor at the time) George Osborne surprised everyone by making these sweeping changes to the pensions landscape?

Craig Rickman, personal finance editor at interactive investor: It certainly surprised everyone. It was a huge shock. I was a financial planner at the time, and it sent shock waves throughout the the industry. I remember talking to colleagues immediately afterwards.

Because at the time when it was announced, we didn't actually know the finer details. We just,  remember, or those will remember then Chancellor George Osborne, standing up during his Budget speech and saying that people would be able to draw from their pensions however they wish. No drawdown caps. No one would have to buy an annuity. It was an enormous change.

And I think that the tricky thing was then going out and talking to clients without knowing exactly how this was going to look and what options would be available to them in a year's time. So there were some really interesting conversations to be had there. But, yeah, an an enormous change to the pension landscape as it has turned out.

Kyle Caldwell: Well, at the time, I was a personal finance reporter mainly covering investments at The Daily Telegraph. We sat there as a team and we watched the Budget. And it was just a complete game changer for the pensions industry and covering personal finance in general as well. Because as you say, Craig, most people prior to the freedoms bought annuity, but then these changes meant that going forward, people could have a lot more control over their retirement plans and how they how they invest at retirement. They could choose to keep their money invested at retirement and then decide to pay themselves an income, either doing it themselves or using a financial adviser. And I think it really shifted the onus of responsibility to the individual to take control of their finances both before and after retirement.

So, Craig, let's take a step back. Could you explain what actually changed? Why did most people have to buy an annuity? I think that's a good starting point, and then could you talk through what then changed with the pension freedoms.

Craig Rickman: The pension freedoms essentially have allowed you to draw from your pensions however you wish. So whether you want to take the lot out in one go, whether you want to buy guaranteed income using annuity, as you've just mentioned. So that option has still been on the table. As you say, that was the most popular before freedoms.

You could do income drawdown, where you keep your money invested into a flexible income throughout your life, or you could take chunks out of your pension as and when you like - partial withdrawals. But before (the pension freedoms), most people bought an annuity. Drawdown was available, but there were caps. There were caps from what most people could could draw out,  capped drawdown.

There was a form of flexible drawdown like we're seeing now. You needed a a certain amount of guaranteed income (a year) in in the first place. That was initially set at £20,000, but it reduced down to £12,000, which was probably the first indications of a shift towards the the freedoms. But that guaranteed income had to come from things like the the state pension, defined benefit pension income, or annuity. But then you could take out the rest of it flexibly if you wanted to, but that wasn't open to everyone.

That was only open to to basically those who had more significant retirement savings or healthy defined benefit pension. So, basically, what the freedoms did is they opened that out to everyone and said, you can take your pensions wherever you wish, which is a massive, massive change.  This has caused some huge shifts in how people have are choosing to draw their income. They've been offered this flexibility, and as we will probably discuss, they certainly are making the most of it.

Kyle Caldwell: Let's get straight to that. So you mentioned there's been huge shifts in the way that people are accessing their retirement savings. So could you talk us through what the data shows on that in terms of the split between people keeping their pension invested or buying an annuity?

Craig Rickman: Sure. So the Financial Conduct Authority (FCA), the City watchdog, has gathered and published data throughout pension freedoms. We'll look at a a couple of pieces of the data here. I mean, there's been loads and loads and loads, but we'll we'll focus on a couple of parts of it.

So this data shows what people did with individual pots when accessing it for the first time. That part is important. We only have nine years worth of data because the numbers for the 2024-2025 tax year won't be available until later this year. So we've only got nine years, but still it gives us a really good idea about what people have done in response to this greater freedom and choice and and whether they've embraced it. The other part of the data is what it is meant in sort of monetary consideration.

So how much money has gone into the various different ways that you can access your pension. We'll come onto that part in a bit. But in terms of the the pots and what people have done with individual pots, so while most people bought an annuity before freedoms, and to remind people, annuity is a guaranteed income for life or or a set period, Most people who buy annuities buy a lifetime one. So after the freedoms, only one in 10 pots accessed for the first time were used to buy one. What that means is the remaining 90% was drawn flexibly or was being drawn flexibly in some shape or form.

So let's have a look at the the sort of various options that you can draw flexibly. So interestingly, more than half of the plans were taken in one hit. That may seem quite a striking figure. So full pension in cash, money taken out, pension closed down. However, two-thirds of these were worth less than £10,000, and about 90%, nine in 10, worth less than £30,000.

It's generally been smaller pots. We'll come back to that in a second. So that leaves us with the remaining two-thirds. So three in 10 plans accessed for the first time went into income drawdown, where you leave your money invested and you sort of take money out whenever you like. So that's become the most popular retirement income product or strategy.

And then the remaining 6% was partially withdrawn where you take some of your money tax free and the rest is taxable. That's some horrendous piece of jargon called uncrystallised funds pension lump sum (UFPLS), but it's just a partial withdrawal where some is taxable and some isn't. So that's one side of the data.

The other is the monetary consideration. So the data here only stretches back to 2018-2019. So it doesn't span the whole of the freedoms, but it does give some sort of an overwhelming view of what people have been doing. So interestingly, seven pounds in every £10 of pension money access for the first time entered drawdown. So sort of emphasising its place as the preferred retirement strategy.

So as stated above, while more than half of pots were fully cashed in, these amounts were small. So only one pound in every nine was withdrawn using this method. So that emphasises that the people who were taking or withdrawing pots in full, these pots were generally kind of relatively small.

And the same with annuities and and partial withdrawals. So, again, about one pound in every nine. So what we can see is drawdown is what most people have been doing, particularly if they've got larger pots of money. And by bigger pot, we're probably talking sort of a hundred thousand pound plus.

The vast majority of money has gone in into income drawdown, and people are drawing a flexible income.

Kyle Caldwell: And, of course, withdrawing a flexible income, you have greater freedom, but then you also have greater personal responsibility. I remember at the time that the pension freedoms were announced, Sir Steve Webb, who was the pensions minister at the time, made the tongue in cheek remark that pension savers could use their pension pots to splash out on a Lamborghini. Now at the time that comment was made, rather than viewing it as a negative comment on the risk of pension pots being drained, I thought it was more made as an educational piece to get across the flexibility that these pension freedoms had given people and the fact that 25% can be taken tax free from the pension pot, including when taking as an income by keeping it invested during retirement.

Craig, what does the data show in terms of how people have been approaching the pension freedoms, in terms of how much they've been withdrawing? Of course, there is the risk of draining your pension pot too soon, particularly if your investments underperform and if the pension withdrawals you're making are overly aggressive?

Craig Rickman: Yes. Well, again, we'll we'll we'll turn to the FCA's data on this. And this is the most recent recent data, which is from the 2023-2024 tax year. So this focuses on regular withdrawal percentages based on pot size. And what we can see is I mean, pot size is a big determinant here.

So for those who have got smaller pots, they're typically taking out larger amounts. So amounts greater than or equal to 8% is by far the most popular withdrawal percentage. And that kind of carries on all the way up to as you get to sort of 250,000 and above, and then it reverses. So for those with bigger pots, the two most popular sort of group percentage groups for withdrawals are less than 2% and between 23.99%, which is really interesting. Again, this is only on individual pots, so it's quite possible that someone could have a smaller pot and be taking quite a lot out and have a larger pot and being a bit more conservative with the withdrawals.

So it doesn't tell us everything, but it does give us an idea about what people are doing. And, again, we don't know for each individual whether what they're doing is suitable. That's a personal thing. I guess the thing to add as well is the investment conditions since freedoms on the whole have been have been pretty good, potentially in the past few years. So even if you're drawing out 8% of your pension every year, whatever the size is, provided you've had good exposure to equities over this period, it probably hasn't done you a great deal of harm.

The big question now is is what's going to happen in in the next ten years? We've seen a return to investment volatility recently. We don't know whether this is going to continue, but I think it sort of stresses the importance of examining your your drawdown strategy at least once a year if you are withdrawing specific percentage out, and that's what you're aiming for.

Kyle Caldwell: In terms of withdrawing a percentage each year, often cited is the 4% rule. So the theory is that if you take 4% out, then your retirement pots will potentially last for thirty years or more. However, it's a rule of thumb, and it does not offer any certainty. And, of course, there are many unknown future variables that could impact whether taking 4% will prevent you draining your portfolio too soon. What are your thoughts, Craig, on this 4% rule of thumb?

It was a financial planner who came up with the the rule, and I think it was in the 1990's he came up with it. It was quite a long time ago.

Craig Rickman: Yeah. The Bengen rule. It's got a few names. Bengen rule, safe withdrawal rate. But, yeah, I think it could be seen as a good guide, a good starting point, but nothing more than that really.

And it's not an overly aggressive withdrawal rate, 4%. So as long as markets haven't performed particularly badly during the periods that you you'd be drawing 4% out of your portfolio, it should be enough to see through your retirement. Again, unless you unless markets performed badly and you lived for a particularly long time. But, I mean, the the problem with the 4% rule or any rule of thumb for that matter is that it's not personalised, And I think that's the key when managing a drawdown pot. And like you said at the start, unless you're taking financial advice, it's up to individuals to to manage that.

And so picking a withdrawal rate at the start when you enter retirement and then just hoping that's going to see you through can be quite a risky thing to do, even something as conservative as 4%. Any withdrawal set strategy should be tailored to to yourself, your circumstances, how much income you need. And in an ideal world, you'd review it regularly at least once a year.

Kyle Caldwell: Another tactic if you focus on income-producing investments in your pension portfolio is to consider only taking the natural yield, particularly when stock markets are volatile as indeed they have been over the past couple of months. So let's say, for example, your portfolio is yielding 4%, but you instead decide to take 6% or 7%. In that scenario, when stock markets fall sharply, then it is going to become more difficult for your pension funds capital value to recover afterwards. Whereas if you only take the natural yield, then you're given the capital much more protection and given it more of an opportunity to regain value. The phenomenon is known as pound cost averaging, which is the inverse of pound cost averaging.

Craig, another rule of formal tactic for an income producing portfolio is to consider having a separate cash pot or indeed pots, which could be then utilised during a lean periods. Could you talk us through this approach?

Craig Rickman: This is this is a fairly common tactic that investors drawdown investors use, and it typically involves keeping around two to three years expenditure in cash. You can hold either more or less than that. Again, it will depend on, I guess, your your attitude to risk. That'd be a big factor there. But the idea of holding a cash pot is to avoid selling shares when markets are going through a tough patch.

So you mentioned one of the risk pound cost ravaging, a similar one is sequencing risk. These are most acute in the early years of retirement. So if you can imagine if your retirement portfolio dropped and you continue to sell shares to supplement your income, then you'd need to sell more shares to deliver the same level of income. So that means it is going to affect how quickly your pot can rebound in the future, and you're more likely to deplete it quickly. So the idea of having a cash pot is to tie you over until markets recover so that you don't have to in cash shares.

So it's a a bit of a safety net, I guess. The one key thing to remember if you are going to use that strategy is if you do deplete your cash pot is to top it up in the future, so that when the next slump arrives, you've got some protection.

Kyle Caldwell: I think in terms of having cash pots as well, it also depends on how much money you've actually got. Some people may not be in the position to have those cash pots and may need to keep the majority of the portfolio invested and maybe have a smaller cash position.

Craig Rickman: Yeah. And just to add, how much to keep in cash is quite a big decision because, you know, holding too much can drag on on portfolio performance. So there's a there's a there's a sort of a fine balancing act there. So you want to keep enough so that you feel like you're secure, that you've got a peace of mind, that if markets do take a turn, then you've got that cushion, but try not to hold too much that it's going to affect how quickly your portfolio grows.

Kyle Caldwell: Next I wanted to turn our attention to a key feature of the pension freedoms, which is the tax free lump sum. This is the ability to withdraw a quarter of a pension pot tax free. This could, for example, be used to meet immediate financial obligations, such as paying off a mortgage, clearing debts, helping children onto the property ladder. The tax free lump sum is capped at £268,275. Of course, you don't have to take all of the 25% all at once. It can also be taken in stages or instalments. Craig, could you talk us through why some people may decide to do it that way rather than take it all at once?

I assume the latter is more popular in taking it all at once.

Craig Rickman: Yeah. So I think taking it all at once is the most popular decision for a lot of people. But you can take it in stages. So this goes back to, what we mentioned earlier about uncrystallised funds pension lump sum (UFPLS).  So that's a way that you can sort of just draw chunks out of your pension. Some of it is taxable. Some of it is tax free. So it's a way just just to to to to use your tax free cash in stages.

So as an example, let's say you had £100,000 in your pension and you wanted to take out and you took out £10,000 using UFPLUS, 25% of that amount, so £2,500 would be tax free and the rest would be added to your tax bill. The real benefit here is that not drawing all your tax free cash in one go is that it can remain in your pension and and potentially benefit from future growth, which could mean a bigger tax free lump sum down the line.

You can take it all in one hit. Whether you should do that is is a personal decision.

An alternative approach is to crystallise certain chunks of your pension and move it into drawdown. So, again, if you had £100,000 pot and you wanted to move 25% of that, £25,000 into drawdown, you could take 25% of that tax free, and then the rest would be there in, a separate drawdown pot.

So, there's there are few ways that you can use it, and I think that's been one of the great things about pension freedoms is is the flexibility that it offers in in not just how you can draw an income from your pensions, but also how you can withdraw the tax free cash element.

Kyle Caldwell: And in terms of what people typically do with the lump sums they encash from their pensions, we've actually done some research on this in the interactive investor Great British Retirement Survey. Craig, could you talk us through the key findings?

Craig Rickman: I can indeed. So this is from our great British Retirement Survey in 2023. So we have some stats here to note that people have used or would have used the the tax free cash element for more than one purpose in some cases.

But these are the most popular, and it's pretty interesting: 39% withdrew the tax free cash and put the money in a bank or building society, 25% used some all of it to clear debts, 19% went into a cash ISA, 12% used it to help children. And then interestingly, only 11% used it to invest in the stock market either in an ISA or something else. So some pretty clear results here.

Cash savings and bank accounts and clearing debts are by far the most popular choices.

Kyle Caldwell: I think it's a really interesting finding that most people are putting it into banks or building societies rather than investing the money. Of course, it depends on your attitude to risk, objectives, and timescale. But, if the money is for ten years or more, history shows that the best way to keep pace or beat inflation is to invest it rather than put it into a cash account. And, of course, depending on what age you are when you retire, you could have a very long term time horizon. I mean, at the moment, you can access your private pension at age 55, which is rising to age 57 in April 2028. You could hopefully have a thirty or even forty year time horizon, and we know over those time periods, Craig, the stock market does tend to beat cash.

However, it is important to have rainy day savings, and, of course, everyone's personal circumstances are different. So it is hard to pass on comments about whether each individual has done the right thing.

Craig Rickman: Yeah. Absolutely that. I think it's again, and that's been a bit of a a thread that's been weaved throughout. This is that this is these are all personal decisions.

Some people could have put the money into a bank account, but then had some short-term plans for it to use it in in a couple of years, but that was the immediate destination. But I think, you do have to be a little bit careful when when sort of keeping especially if large amounts in cash as if you move them out of your pension because if money in a bank account is taxable, Cash ISAs interest is tax free, but in in a bank account, the money is taxable. It doesn't necessarily mean you'll pay tax. There's something called the savings allowance. So if you're a basic rate taxpayer, you can earn a thousand pounds in savings and pay no tax in it, or the first thousand pounds you earn is isn't isn't taxable. If you're high rate taxpayer, that reduces to £500.

The thing is if if you are withdrawing your 25% tax free cash make sure that you've got some plans for it.

Kyle Caldwell: And to finish off, let's end where we started. So it's often pitted against each other, keeping your money invested at retirement versus buying an annuity. But, of course, it's not an either or decision. You could, of course, do both, particularly when you get older as annuities do tend to become better value when you get older, such as when you get into your seventies. What are your thoughts, Craig, about mixing and matching between the two?

What are the main considerations?

Craig Rickman: But, again, it is a very personal decision. There's really no right or wrong approach when it comes to to whether you want a guaranteed income or whether you want to draw the money flexibly, only the most suitable strategy for you. I think you should add that that that how you choose to draw retirement income is among the most important financial decisions you make. So it's important to think carefully about well, before you do anything.

It's particularly with annuities because with lifetime annuities, it's a one and done decision. Once you bought one, you can't change your mind. The terms you choose are fixed for the rest of your life. So you do need to think carefully before buying one. But when comparing the two, pitting them against each other, the decision essentially boils down to whether you want a secured income that's guaranteed, but it's very rigid that you can't change. It's fixed.

Or whether you would prefer to keep the money invested have the flexibility to draw the money out as and when you please, but are also comfortable with some level of risk as well because that money's going to remain invested. Then it's up to you to make that money last. So, one thing that people may consider is a is a blended approach. You don't have to do either or. You can do a bit of both.

So you may secure a guaranteed income through an annuity to cover a certain amount of expenditure. Let's say that's the essential spend, and then keep the rest in in drawdown to draw flexibly. So you've got kind of the best of both worlds. But that, again, that approach may not work for everyone. There are people out there who will be like, well, I'm particularly particularly cautious and just want to buy an annuity, and there are others who will just use drawdown.

I think the other thing to add is that if you're using drawdown at the moment, you can switch to annuity in the future if you want. So that option is on the table. If you buy an annuity, a lifetime annuity, you don't have the option to switch to drawdown down the line. So, you know, there's a lot for people to think about, and it's important to think carefully about it and take advice if you need it.

Kyle Caldwell: And throughout this podcast, we've probably used the word flexibility more than any other because that really is a key part of the pension freedoms that you have the flexibility to invest your money at retirement rather than being compelled to buy an annuity, which for many was the case before the pension freedoms as Craig explained earlier. Looking ahead Craig, do you think all the flexibility of the pension freedoms are going to be dented a little bit by the fact that from April 2027 inheritance tax will apply on unspent pension pots?

Craig Rickman: Well, it would certainly reduce the allure of cascading pension pots down generations. There's some evidence to suggest that people are already looking to spend their pension savings sooner, to get ahead of these reforms, either spend the money or gift it. So, yeah, it is going to have a huge impact. We should note that the final rules are yet to be confirmed by the government.

We're still awaiting those, eagerly awaiting those, but we'll certainly be looking out for them. But I think either way, this, impending change, which means that, yeah, unspent pensions will form part of people's estate, will have some impact on how people access their retirement savings for the next ten years of pension freedoms.

Kyle Caldwell: Well, thanks to Craig, and thank you for listening to this episode of On The Money. If you enjoyed it, please follow the show in your podcast app and do tell our friends about it. If you get a chance, leave us a review or a rating in your podcast app too as they really help to get the podcast into more ears and hopefully grow the podcast further. You can join the conversation, ask questions, tell us what you'd like to talk about via email on OTM@ii.co.uk and do check out the interactive investor website, ii.co.uk, for much more information and practical pointers on how to get the most out of your investments. And I'll see you next week.

On The Money is an interactive investor (ii) podcast.