In our weekly series, readers can email in with any question about retirement and pension saving to be answered by our expert, Tom Selby, director of public policy at investment platform AJ Bell. There is nothing he doesn’t know about pensions. If you have a question for him, email us at [email protected].
Question: I turn 66 next year and planning to slow down from work. I have the option of completely retiring or staying on two or three days per week. My pension is worth just over £400,000 and I will also be entitled to a state pension of around £12,000 a year. I like the idea of drawdown but how do I make sure my retirement pot lasts as long as I do?
Answer: For those who aren’t familiar with the jargon, “drawdown” is simply a flexible way of taking a retirement income from your pension pot. If you opt for drawdown, your retirement fund will remain invested and you will take an income from your fund as you see fit. You will also be able to access up to a quarter of your pension completely tax-free at this point, which in your case would be up to £100,000 if you put the remaining £300,000 in drawdown.
The maximum tax-free cash most people can take in their lifetimes is capped at £268,275 in 2024/25, although some people with “protection” may be entitled to more than this.
When you take a drawdown income, your withdrawals will be taxed in the same way as income, meaning it often makes sense to drip feed these withdrawals to minimise your income tax bills. Taking a taxable drawdown income will also trigger the “money purchase annual allowance”, reducing your “annual allowance” (the total amount that can be contributed tax-free to a pension each year) from £60,000 to £10,000.
The fact you are thinking about making sure your pension pot lasts throughout retirement before accessing it means you are already off to a good start. Drawdown offers significant potential benefits in terms of flexibility and allowing you to devise a retirement income plan that suits your needs, but the major risk you need to manage is that you take too much, too fast and end up running out of money in your later years.
There is no hard-and-fast rule for how much someone can safely take from their fund in drawdown. This is because of the sheer number of factors that can shift the dial one way or the other.
For example, if your investments deliver strong performance, your fund might be able to support larger withdrawals than if your investments suffer big losses, particularly in the early years of retirement.
Equally, someone who is healthy and expects to live for 30 years in retirement will likely need to take less per year than someone who has a life-limiting condition which means their life expectancy is only 15 years.
To give you a very rough idea of what might be sustainable, let’s take someone who has taken their 25 per cent tax-free cash and has £300,000 invested in drawdown. If we assume they live for 25 years in retirement, their fund grows by 4 per cent per year after charges and their income rises by 2 per cent per year to keep up with inflation, they could take a starting income of around £15,000 a year. If they lived an additional five years, that sustainable starting income figure drops to around £13,000 a year.
Given the number of things at play here, it is absolutely crucial you set a sensible withdrawal strategy and review your plan regularly – at least once a year. If your investments deliver good performance, you might be able to edge your withdrawals up a bit if you need to. If they move in the other direction, you may need to tighten your belt to ensure you aren’t risking running out of money in retirement.
If you don’t like the idea of taking investment risk in retirement or managing your withdrawals, you may want to consider buying an annuity instead. This is an insurance product which pays you a guaranteed income throughout retirement, meaning you don’t have to worry about engaging with your fund or managing the risk of you outliving your pension. If you opt for an annuity, you will forgo the ability to flex your income to suit your needs.
It’s also worth remembering that you can mix-and-match annuities with drawdown to suit your needs and circumstances. For example, you could choose to buy an annuity to cover your fixed costs and retain flexibility and the potential for long-term growth in the rest of your fund. Equally, you could choose to enter drawdown in the early years of retirement and shift to an annuity later in life, when you should get a better annuity rate.
