The risks of drawdown
Drawdown – sounds simple but it’s complicated
Drawdown is easy to understand – you simply invest your pension pot in suitable investments and then you take income payments when you need them.
The income can be regular monthly / quarterly income payments or ad hoc payments or a combination of both. You have total flexibility and there are two things to watch out for; don’t pay too much tax and be careful not to run out of money.
When you die, any money left in your pension pot can be left to your beneficiaries. There will be no tax for them to pay if you die before age 75 and after that they will tax at their marginal rate on any money they take out.
What can be simpler? Everybody will be familiar with having money in their bank account and drawing money out to pay everyday bills.
Drawdown is just like having your own personal bank account – I am being over simplistic but the analogy is a good one.
Drawdown is now the preferred way of converting a pension pot into income as it gives people the flexibility to take their income as they want and gives them control over their investments.
So why is it so complicated?
One of the many paradoxes of drawdown is that it is one of the easiest concepts to understand but one of the most complex to manage properly.
(Another paradox is that older you get the more risk you need to take in order to be better off than arranging an annuity. But you should be taking less risk not more as you get older.)
There are many reasons why drawdown is complicated including:
- There is a risk you could run out of money
- There are complicated investment decisions to be made
- You must watch out for tax
- There can be lots of charges, some of which may be hidden
In short, drawdown can a very risky proposition and even if you have a lot of money in your pension pot and a good adviser these risks can be hard to manage.
If you don’t have an adviser and are making your own decisions about investments and how much income is taken you may be taking more risk than is good for you.
Surely you are over-egging the risks?
No, I am not over-egg the pudding I am pointing out the flip side to flexibility and control.
The rise in popularity of drawdown coincides with the fall in popularity of annuities.
At the heart of the matter is the very important issue of peace of mind and security of an annuity against the flexibility and control, albeit with many risks, of drawdown.
Manged properly, drawdown is a very good way of arranging your pension income, especially in the early years of retirment. However, if you get wrong you could end up with much less income than you planned for.
It may an uncomfortable truth, but many people are over-confident with their ability, or their adviser’s ability, to effectively manage the risks of drawdown.
As an adviser, I must practice what I preach and I can tell you that dealing with the complexities of drawdown are much harder than you think.