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Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
The dangers of a drawdown hangover
The Christmas party season is now in full swing, with workers up and down the country preparing to ask themselves that age old question: ‘How much is too much?’
Clearly the booze will be flowing as the festivities get under way. But embarrass yourself in front of the boss after a few too many sherries and you could be left regretting not reining it in for months – or even years – to come.
Retirement investors similarly need to consider how the decisions they make today will affect their best-laid plans for the future. The pension freedoms introduced in April 2015 mean from age 55 you can spend and invest your retirement pot as you see fit.
Careful planning
While some people will still prefer the security of an annuity, an insurance policy providing a guaranteed income for life, many now use a self-invested personal pension (SIPP) to keep their money invested while taking an income through drawdown.
But how much should you take from your pot each year? Traditional theory suggests that, on average, a 65 year old should be able to draw about 4% of their pot down each year and be confident their pension will last throughout their retirement. While you shouldn’t necessarily follow this to the letter, it provides a useful rule of thumb when thinking about your retirement income strategy.
Most people think of their income in terms of pounds and pence, rather than percentages. So let’s take Gareth, a 65 year old retired technician. He has £100,000 left in his defined contribution pot after taking his 25% tax-free cash, a defined benefit pension worth £5,000 a year and a state pension that provides £8,000 a year. He needs £17,000 a year income, so takes £4,000 from his DC fund in year one.
However, his investments struggled terribly as uncertainty over Brexit hit his UK-heavy equity portfolio. As a result, his total pot is worth just £80,000 at the start of year two. To stay within the 4% rule Gareth must now reduce his total income by £800, withdrawing £3,200 from his DC pot. If he withdraws £4,000 again, that represents 5% of his total pot value.
This scenario could work the other way. If Gareth’s portfolio rises in the early years of his retirement then his original £100,000 could still be intact – or even higher – even after he has taken his £4,000 annual income.
The watchword here is sustainability. Sustainability when it comes to drawdown is likely to be a moving feast, so keep an eye on your portfolio and think about the impact your spending decisions today will have on your quality of life tomorrow.
TOM SELBY
Senior analyst, AJ Bell
Important information:
These articles are provided by Shares magazine which is published by AJ Bell Media, a part of AJ Bell. Shares is not written by AJ Bell.
Shares is provided for your general information and use and is not a personal recommendation to invest. It is not intended to be relied upon by you in making or not making any investment decisions. The investments referred to in these articles will not be suitable for all investors. If in doubt please seek appropriate independent financial advice.
Investors acting on the information in these articles do so at their own risk and AJ Bell Media and its staff do not accept liability for losses suffered by investors as a result of their investment decisions.