Pros and cons of flexi-access drawdown

But although people could take out flexi-access drawdown, or even convert from their capped drawdown into flexi-access drawdown products, post pension freedoms being introduced in April 2015 this has not happened in the droves expected.

As Greg Kingston, head of communications, product and insight at Suffolk Life, comments: “Our experience is only limited numbers converted from capped drawdown to flexi-access.

“The primary reason for this was wanting to retain the normal annual allowance from contributions rather than the more restricted money purchase annual allowance (MPAA).”

Advantages

While it may still be early days, there are several advantages to flexi-access drawdown schemes.

Freedom and flexibility are the biggest draws.

It is really important to balance the benefits of flexible withdrawals with a sustainable income strategy that will last in retirement Adrian Walker

According to Mr Kingston: “The freedom given by flexi-access drawdown means a pension fund can simply be operated with the same principles as a savings account or other investment.”

Rod McKie, head of retirement proposition for Zurich, comments: “This gives people complete flexibility over how they get, and draw down from, their pension savings.

“This can be particularly helpful for managing unexpected events or changing life circumstances.”

Mr McKie says while capped drawdown can meet many of these needs, as well as maintaining an upper limit on withdrawals which could help people manage their money better over a longer time, he says flexi-access drawdown is a “better fit” for modern retirement.

He adds: “Overall, flexi-access drawdown is a better fit for modern retirement where income is usually supplemented by other sources.”

Using flexi-access drawdown can help customers to minimise tax liabilities, Mr McKie added. He explains: “It is potentially well suited for customers with smaller pension pots seeking to withdraw their funds in a tax-efficient way.”

Also, as John Lawson, head of financial research for Aviva points out, there is the ability to pass on money at death tax-efficiently.

“A flexi-access drawdown fund does not form part of the deceased’s estate for inheritance tax and the money passed on it taxed at the beneficiaries’ rates of income tax, which could be low or zero.”

Spanner in the taxworks

But sometimes clients may push themselves into a new tax band.

Colin Parkin, managing director of Ample Financial Services, suggests clients should ask whether they need to use drawdown, when, and how much.

He explains: “A lot of people want to retire on the state pension at 67 but are thinking of taking their work pension at 60 and working the remaining seven years.

“However, even if they are working part-time or in a different role, if they take drawdown and work as well, they could be pushing themselves up into a higher-rate tax bracket.

“Even if they take out the bare minimum of their yearly tax allowance they could still be pushed up based on what they are earning.”

Also, they could end up with an emergency tax imposed. Although providers are legally obliged to operate pay as you earn (PAYE) on taxable payments, not all providers can process PAYE refunds without the member requesting an additional withdrawal.

Therefore, advisers will need to understand how the tax codes work.

A helpful factsheet from James Hay Partnership produced last tax year presented a range of case studies of clients using flexi-access drawdown and how they could be taxed in various scenarios.

For example, Norris wants to withdraw £20,000 gross under the flexi-access rules. He already receives gross annuity income of £15,000 a year and has no remaining pension commencement lump sum (PCLS). The tax deducted from his annuity income is £880. He has no other income sources, and is entitled to the basic personal allowance.

When he withdraws £1,000 in June 2015 as a one-off payment, the M1 emergency tax code is applied. This means his tax is based only on what he is paid in the current pay period, not the whole year. This is how his tax position would work out:

Source: James Hay Partnership

Individuals who do not entirely exhaust their funds should take care to ensure their withdrawals take advantage of this real-time PAYE system during the tax year.

Disadvantages

There are three main risks with drawdown products that clients need to be aware of: longevity risk (they could outlive their savings); inflation risk, whereby changes could erode the purchasing power of the savings, and sequence risk.

The fastest way to outlive ones savings is to take out too much, too early. Adrian Walker, retirement planning expert for Old Mutual Wealth, comments: “It is dangerous to measure the success of pension freedom against the amount of money people are taking out of their long-term savings.

“The figures show in quarter two this year, more than £11,000 was taken out on average by individuals accessing their pensions flexibly.

“This suggests some people are at risk of winding down their savings too quickly. It is really important to balance the benefits of flexible withdrawals with a sustainable income strategy that will last in retirement.”

Sequence risk (or ‘sequence of returns risk’) relates to the investment performance of the pension pot immediately after retirement, when the investor stops paying into the fund and starts to draw down.

Saving for a retirement fund carries an element of risk, and with flexi-access drawdown that risk continues Greg Kingston

If the underlying investments were to suffer heavy losses in the first few years of retirement - for example, those people suffering a ‘lost decade’ of returns in 2008 when global markets crashed - this will significantly affect the individual’s ability to fund their later years.

Big negative returns early on will affect the capital that remains, especially if a lot of money is being drawn down in the first few years of retirement.

With 10-year UK gilt yields being at a record low after the UK base rate was cut to 0.25 per cent, investors are becoming obliged to take more risk and manage their pension assets for longer, as Mr McKie points out.

As Mr Kingston says: “Saving for a retirement fund carries an element of risk, and with flexi-access drawdown that risk continues.

“Drawing out too much income, or drawing out income when the fund size is low will reduce the size of the retirement fund, and with it the ability to sustain the same level income into the future.

“With limited or no means to top up the balance in retirement, once it is gone then it really is gone.”

John Lawson, head of financial research for Aviva, comments: “Like all drawdown, flexi-access drawdown requires careful management to ensure the saver does not run out of money before they die or draws too little and doesn’t experience the retirement lifestyle their savings could have afforded.”

Pound cost ravaging

Therefore, to enjoy the full benefits of flexi-access drawdown does not just depend on the size of the pot, the track record of the provider or the skill of the adviser.

It also depends on how the client is invested, lifestyle investment strategies, expected life span post-retirement and the effects of inflation, investment volatility and ‘pound cost ravaging’, as Standard Life points out.

A 2014 white paper from Standard Life Investments, The Investment Challenges of a Decumulation World, presented a case study of a client with retirement age of 60, with a £100,000 pension pot, drawing down £6,000 a year (£500 a month).

It assumes long-term returns of 9 per cent a year and 3.5 per cent inflation a year, assuming investment in global equities.

The graph shows how the pension pot will deteriorate over time - meaning the client may run out of money in his 90s, especially if he has to start paying long-term care fees (currently at £29,558 a year on average, according to Partnership).

Chart 1: Evolution of pension pot over time owing to investment returns and pension payments

Ray Chinn, head of pensions and investments at LV, adds: “There is a risk poor returns in the early years of a drawdown strategy will have a catastrophic effect on fund values and the ability to generate required levels of income in the future.”