How to invest your pension in drawdown

Pension freedom reforms mean retirees can invest their savings how they like rather than buy a stingy and restrictive annuity.

The problem is that while many people dislike the idea of an annuity, the alternative means keeping your pension invested in retirement and managing it yourself – a process that can be confusing and full of pitfalls.

Arguably, that has become an even more daunting prospect in an uncertain world, with stock markets volatile following Brexit, the pandemic, the Ukraine war and a nasty bout of inflation. So, we present a 12-step plan to help you invest your pension wisely.  

What is pension freedom?

Pension freedom reforms gave over-55s greater power over how they spend, save or invest their retirement pots.

Key changes from April 2015 included removing the need to buy an annuity to provide income until you die, giving access to invest-and-drawdown schemes previously restricted to wealthier savers, and the axing of a 55 per cent ‘death tax’ on pension pots left invested.

The changes apply to people with ‘defined contribution’ or ‘money purchase’ pension schemes, which take contributions from both employer and employee and invest them to provide a pot of money at retirement.

They don’t apply to those with more generous gold-plated final salary or ‘defined benefit’ pensions which provide a guaranteed income after retirement.

However, those still saving into such schemes can transfer to DC schemes, provided they get financial advice if their pot is worth £30,000-plus. 

A stream of research has shown that while savers heartily welcome pension freedoms, they often feel baffled and overwhelmed when dealing with the new choices opened up to them.

Annuities offer the certainty of a guaranteed income for life, and interest rate hikes have enabled providers to offer more attractive deals, as we explain below. 

They can still prove the best option for some savers. 

But most people now opt to invest their pot in a drawdown scheme for income and hopefully a bit of growth.

Those who are novices to the world of stocks, bonds and funds might find the whole business something of a challenge, and struggle to manage their investments successfully enough to enjoy a comfortable old age. 

Frequent bouts of market turmoil since 2015, most recently due to inflation and the subsequent run of interest rate hikes, could put off some retirees altogether. 

Financial market volatility can leave people who entered drawdown facing losses, and also in a quandary because taking an income from shrinking investments early on can do disproportionate and irrecoverable damage to a portfolio. 

So here’s our starters’ guide to investing your pension – a checklist of what you need to think about and plan ahead for at the outset of your retirement.

Investing your pension: Getting started

Most people save for retirement by simply diverting some of their salary into their employer’s ‘default’ pension fund, and take little or no interest in what it’s invested in until they get fairly close to retirement.

But taking advantage of pension freedom means moving from that very low level of engagement to choosing a portfolio spread across a number of different asset classes, reviewing the strategy around once a year, and rebalancing investments when necessary.

Some ‘off the shelf’ investment portfolios based on your attitude to risk can be fairly straightforward, though you should still ensure you fully grasp where you’ve put your money.

From February 2021, regulators have forced firms to offer people four ready-made investment deals when they first dip into their pension pots, if they are doing this without paying for financial advice first.

They are designed to help savers avoid common mistakes, such as taking too much risk or sticking with measly rates on cash – but there is no obligation to use them.

You can also pay a financial adviser to do all the work for you, although that doesn’t come cheap – perhaps between £1,000 and £2,000 if you have a just a handful of pension pots amounting to about £100,000. 

But that doesn’t include investment and admin running costs, or the annual percentage fee an adviser will levy on your pot if you want them to monitor your investments and keep them on track.

However, you can opt for one-off financial advice at retirement and then manage your investments yourself. 

To help readers who want advice, This is Money has partnered with financial planning specialist Flying Colours to create a find an independent financial adviser service.

The chances are that even if you put your money in some kind of pre-packaged investment scheme, or are willing and wealthy enough to hire an adviser to create an individual portfolio, you will have to learn about what you’re investing in anyway just to stay on top of performance and ensure you aren’t being overcharged.

If you are new to investing this might all sound alarming, and even make you think just buying an annuity would save a great deal of hassle.

But there is an army of amateur investors out there who all had to start somewhere. There are no guarantees, but investing your pension could prove financially rewarding if you do your homework, use your common sense, and accept that it involves the risk of bad years as well as good ones. 

1) Choosing a product: What’s on the market

Income drawdown schemes allow you to take sums out of your pension pot while the rest remains invested. A lot depends on what you are invested in and how well it performs.

At its simplest, a drawdown scheme is simply an investment portfolio geared towards being able to withdraw an income to live on but preserving enough capital so it doesn’t run out before you die.

Some will come pre-packaged, with investments chosen to reflect your attitude to risk, but you will need to look at them to decide whether they suit your needs. With others, you will need to be pro-active about choosing investments, or pay a financial adviser to do it for you.

There are four ready-made deals which firms are mandated by regulators to provide to retirees. They cover the following four basic scenarios.

1. I have no plans to touch my money in the next five years

2. I plan to use my money to set up a guaranteed income annuity within the next five years

3. I plan to start taking my money as income within the next five years

4. I plan to take out all my money within the next five years.

Another option is to buy a fixed-term annuity – the name has ‘annuity’ in it but it is a really a short-term product that allows you to defer a decision on how you fund retirement.

The length of the term can vary but it is often two, three or four years, and they have the advantage of not being irrevocable like a typical annuity which lasts the rest of your life.

There is also the option of going for a hybrid annuity-drawdown option – effectively, splitting your pot in two. You can buy an annuity that provides enough guaranteed income to cover your basic expenses, then put the rest into a drawdown scheme to try to grow your retirement savings further.

However, this is not considered a good idea for people with smaller savings pots, due to the extra costs and hassle of both buying an annuity and setting up a drawdown plan. 

An annuity/drawdown scheme that comes packaged up into one could also turn out to be less flexible and carry more costs.

If you are looking for investment growth and a guaranteed pension, we looked at how to combine drawdown and annuities to maximise retirement income here.

2) Income: How much to take – and what if your portfolio tanks

The level of income you decide to take every year from your drawdown scheme can be crucial.

After the pension freedom reforms, there aren’t any restrictions on what you withdraw from your pot, but you face the risk of running out of money if you make unwise decisions.

The rule of thumb, based on US research, used to be that you were probably safe to take out 4 per cent of your fund a year without serious consequences, but some experts say it should be more like 3.5 per cent.

So what happens if you get the income level wrong? 

You could suffer the triple whammy of falling capital value of the fund, further depletion due to the income you are taking out, and a drop in future income – this is known as the pound cost ravaging trap .

For example, if a £100,000 fund falls 10 per cent in value in a year to £90,000 and you take out £7,000 as income, that means your fund has dropped to £83,000. 

And because you now have a smaller fund, when you review it you will probably have to reset income to a lower level.

On top of that, people who persist in taking an income in the initial years will crystallise their losses and pile up problems for the future. 

Taking an income from shrinking investments early on can do disproportionate and irrecoverable damage to your portfolio, because it is much harder to rebuild it to a position of strength.

You do have options if your income drawdown portfolio is tanking.  

They include using up cash and other assets before tapping it, making fixed percentage not fixed sum withdrawals, relying on ‘natural’ income generated from dividends rather than growth, and revamping your investments. 

3) Tax: Don’t over-pay the taxman by mistake

Unwary retirees can find themselves heavily taxed for withdrawing big sums from their savings. Only 25 per cent of retirement pots are tax-free while the rest is taxed as income at the usual 20 per cent, 40 per cent and 45 per cent rates.

Workers used to simply paying the basic 20 per cent rate of tax through employers might not realise that dipping too freely into their pension pot at retirement will put them into the higher rate tax bracket and on the hook to the taxman for more than they expected.

After you take the first 25 per cent, you can withdraw your pension savings in small amounts over a number of years to avoid hitting a higher tax threshold.

Since the freedom reforms, savers aren’t limited to one chance to take a single tax-free lump sum worth 25 per cent of their pension pots, with the rest taxed as income afterwards.

You can now dip in and make as many withdrawals as you want, each time getting 25 per cent tax-free and the rest taxed like income. If your investments do well, you will be doing this from a growing fund or one that keeps replenishing to around the same level even after withdrawals.

However, if you take any amount over and above your 25 per cent tax free lump sum, you are only able to put away £10,000 a year and still automatically qualify for tax relief from then onward. 

This is intended to put people off recycling their pension withdrawals back into their pots to benefit from tax relief twice. 

Meanwhile, your first taxable withdrawal can be hit by ’emergency’ taxation, although you will get any overpayment back. 

Read our guide to defending your pension from the taxman here. 

4) Minimise risk: Diversify your investments

People nearing retirement traditionally switch savings out of risky investments and into safer assets, but pension freedom reforms have prompted a big rethink of this practice.

That’s because derisking your pension savings – or ‘lifestyling’ them, as it’s known in industry jargon – is normally done in preparation for buying an annuity.

When you trade in your nest egg for an annuity, you want it to be as big as possible – you wouldn’t want to risk a big drop in its value just before. 

However, if you’re not planning to take all of your pension the minute you retire, a drop in value at retirement age is not such a big deal as you still have time to bring it back up again, and may be worth the risk in exchange for the possibility of higher returns.

Under pension freedom, most people choose to not buy annuities. And if you want to stay invested, it is more more sensible not to derisk, which usually involves moving your money from stock market-linked investments into corporate and government bonds and cash.

Some pension providers are already changing ‘default’ funds for people approaching retirement, and not lifestyling them in recognition that savers are being a lot more more creative about how they fund retirement. 

But if you have been put into safer investments, you might have to ‘re-risk’ again when you enter a drawdown scheme – or even rethink your attitude to annuities, given rates have improved again after recent interest rate rises, which can offset the reduced size of your pot. 

Whatever you decide on that front, you will still need to ensure your eventual portfolio is allocated across asset classes in order to spread the risk should one or more financial market suffer a crash.

Asset allocation means the overall mix you have of different types of investments, such as:

* Shares

* Corporate and government bonds

* Cash

* Commercial property

* Alternative investments like private equity and hedge funds, or absolute return funds.

Within the proportion of your portfolio in shares, you also need to think about how it should be split between different geographies and different industries.

There is no single best way to allocate your investments – your decision will depend on your age and risk appetite.

5) Interest rates: Bond market dangers

The Bank of England held interest rates at rock bottom for years after the financial crisis in 2008, but is raising them now to combat inflation, as is the more influential US Federal Reserve.

For people with a pension fund invested in retirement, it’s important to keep an eye on what’s going on with interest rates because expectations about them can move stock markets, and because of their impact on government and corporate bonds.

Bonds are commonly held in investment portfolios as a ‘safer’ alternative to shares, and as a way to diversify risk, as described above.

However, as central banks have started to normalise policy and raise interest rates again, many investors have decided they overbought bonds and dumped them in a hurry. 

It’s also worth noting that one of the reasons annuity rates have been so poor in recent years is that low interest rates have driven down the yield from gilts – UK Government bonds that are used to produce annuity income.

Higher interest rates have led to better annuity deals and made them a more attractive option again.

6) Review your investments: Don’t ‘set and forget’ your portfolio

You should carry out a full health check on your investments at regular intervals – many experts suggest once a year. 

Don’t do checks too often though, or you risk being tempted into constantly making small changes and racking up extra costs.

In fact, it’s a good idea to always carry out your overhaul at exactly the same time each year, to achieve continuity and build up a helpful performance record.

If you find the task a chore, remember you will have more time in retirement to spend on jobs like this, and that to just ‘set and forget’ your investments could cost you dear.

If you used a financial adviser to set up your drawdown plan they will carry out reviews for you, and rebalance your portfolio if necessary, although naturally this comes at a price. 

This is typically a percentage fee levied on your overall pot.

> How to carry out your own annual healthcheck on your investments 

7) Fraud: Keep the pension sharks at bay 

Pension scams are horrific – and don’t assume you would never fall for one. 

Some of the investment wheezes fraudsters tout can sound very tempting when compared with the vanilla portfolio described above. But that’s an intentional ploy to lure you with big and so-called ‘guaranteed’ returns.

Citizens Advice carried out a survey where it initially asked more than 2,000 people whether they thought they could identify a fraudulent offer. 

Then it presented them with three mock adverts and asked which they were most likely to pick if they were looking for help with their pension.

Some 88 per cent of people who took the survey chose one of the frauds. Among those who had expressed confidence about detecting scams, almost exactly the same proportion, 87 per cent, selected one of these offers.

Some 64 per cent of all those asked chose the advert which touted the highest investment return rate of 15 per cent, suggesting people are particularly vulnerable to scams promising the biggest financial rewards, however unrealistic.

Pension freedoms are thought to have created a more fertile hunting ground for conmen, because over-55s are now allowed to access their entire retirement savings, making this money an obvious target for unscrupulous sharks.

Financial experts say the number one step people can take to protect themselves if they get cold called about an investment or pension opportunity is to hang up. 

Cold calling about pensions is banned by law, so it’s a red flag even to be contacted this way.

But be aware that fraudsters use names that are the same or very similar to those of legitimate companies, and have even been known to adopt the names of real staff members and pretend to be them. 

You therefore have to be extra careful you don’t click on the wrong link or call a dubious number yourself.

The FCA’s list of authorised firms is here, and it’s best to use the contact details on there to be certain you are dealing with the right one rather than an impersonator.

The regulator also runs a ScamSmart service, which helps people avoid frauds by checking out offers they have received.

8) Final salary pensions: It’s rarely a good idea to abandon them

The pension freedom changes apply to people with ‘defined contribution’ or ‘money purchase’ pension schemes, which take contributions from both employer and employee and invest them to provide a pot of money at retirement.

They don’t apply to those with more generous gold-plated ‘final salary’ pensions, which provide a guaranteed income after retirement. 

However, if you do have one of these you will want to factor it into your retirement planning. 

Having a guaranteed income from a final salary pension could potentially cover essential bills while you take some investment risk with the rest of your savings.

You also have the option of transferring a final salary pension into a drawdown plan, although financial experts say this is rarely a good idea and the Government has placed safeguards against people giving up valuable pension benefits without realising. 

Transfer values used to be higher because schemes were trying to offload expensive obligations onto pension savers, but now interest rates are higher again there is not so much impetus to tempt people to leave so they have become less generous. 

If your final salary pension is worth more than £30,000, it is compulsory to take paid-for financial advice before giving it up.  

However, some people are willing to give up a comfortable final salary pension and invest the money in an income drawdown scheme instead for inheritance reasons, which are explained below.

9) State pensions: Get a forecast as soon as you can

Many people who build up private savings still rely on the state pension as a bedrock of their retirement arrangements, because it offers a guaranteed income stream for life. 

This is especially important if you don’t have any final salary pensions.

The Government has overhauled the state pension system to introduce a new flat rate for those retiring from April 2016 onwards. This is currently worth £221.20 a week or £11,500 a year if you qualify for the full amount. 

The basic state pension is £169.50 a week or around £8,800 a year.  It is topped up by additional state pension entitlements – S2P and Serps – providing these were accrued during working years. 

People who have contracted out of S2P and Serps over the years and retire after April 2016 may get less than the full new state pension. 

But you can fill gaps in unpaid and or underpaid National Insurance in previous years, make voluntary top-ups to buy extra qualifying years, and build up more years if you have enough time between now and state pension age.

Given its likely importance to your retirement finances, you should get a state pension forecast and factor it into your planning as early as possible. 

10) Ill health and cognitive decline: Set up ‘lasting power of attorney’

Falling too ill to provide for yourself and your family is a devastating personal blow, and will very likely throw your finances into disarray too.

It will be little consolation for the loss of your health, but there are ways to use your pension pot to relieve money troubles should you find yourself in this sad situation. Read our guide to your pension options if you fall very ill.

Meanwhile, people who enter an income drawdown scheme should seriously consider setting up a ‘lasting power of attorney’ at the same time in case they become too ill to run their own finances,

Unlike when you buy an annuity, income drawdown requires someone to manage their investments throughout retirement, until their death.

But you can appoint someone you trust – usually a family member or friend – to take over if you can’t do this any longer by creating an LPA, either independently or by paying a solicitor. 

If you fall very ill without an LPA in place, one of your loved ones can apply to be your deputy. But this involves a long and costly court process, and imposes onerous extra duties on them compared with being an attorney.

11) Inheritance: Passing pensions on to your loved ones 

Using income drawdown to fund retirement has become far more popular following the tax changes on inheriting pension pots that accompanied the freedom reforms.

A 55 per cent tax rate that applied to pension pots in drawdown left to children if the owner dies was scrapped. Instead, beneficiaries either pay no tax if the owner dies before age 75, or their normal income tax rate if they are 75 or over.

This compares to annuities where the capital is usually lost after the death of you and your spouse – although there are some available which can be passed on – and final salary pensions which tend to work in a similar way.

It is worth considering whether there will be enough left in your pension pot to bequeath something to loved ones, but inheritance planning is complex so think about getting financial advice on this issue.

12) Financial advice: Consider paying for help

To prevent people unwittingly giving up valuable pension benefits, the Government has legislated to ensure some savers take financial advice if they want to:

1) Access a defined contribution pot with valuable guarantees – like death benefits or an annuity rate better than you can get on the open market – worth £30,000-plus

2) Transfer or cash in a final salary pension pot worth £30,000-plus.

This has become a source of grievance for some people, who are angry at being forced to shell out for what they believe is costly and unnecessary advice.

Many people are loath to take financial advice. But This is Money Publisher Simon Lambert believes you should seriously think about paying a good professional to help you with your pension.

‘The reality is that even those of us who consider ourselves financially informed may struggle to think of all the things that should be considered,’ he writes.

A decent financial adviser can set you up with a suitable investment portfolio at the outset of retirement. 

If you want their services to start you off, but don’t want to pay hefty ongoing fees throughout old age, an industry expert explains how to ditch your financial adviser if they have served their purpose or aren’t providing value for money. We have a guide to getting one-off financial advice here.

The best ones are worth continuing to pay the annual fee for though, as they will keep your income on track and let you know of important tax and legislative changes.

Tax can get complicated at retirement, when many people who have never filled in a self-assessment form find they have to start doing so, and there are a number of serious and expensive pitfalls for the unwary. 

A financial adviser can help with this, and you might also want to get an accountant to do your tax return, at least in the tax year when you transition from work into retirement. Our tax columnist Heather Rogers explains how to find a decent accountant here.