Drawdown: Lamborghinis and holidays

In my previous post I set out five reasons why I think annuities don’t deserve the bad press they get. In that post I focused specifically on the positives that are often overlooked in assessing annuities. I was challenged, both here and at Monevator, on setting out a similar style argument for drawdown.

I think that’s fair. Because, for my money, drawdown gets a lot of bad press that it too doesn’t deserve. The pension flexibilities introduced in 2015 continue to get hammered for retirees blowing their money on Lamborghinis and holidays. Even when the evidence from the FCA says that’s not the case. In its 2017 interim report on pension flexibilities the FCA found that (emphasis mine):

Over half (53%) of pots accessed have been fully withdrawn: 90% of these pots were smaller than £30,000. Over half of fully withdrawn pots were transferred into savings or investments. Overall, we did not find evidence of people ‘squandering’ their pension savings.

I also want to highlight: “90% of these pots were smaller than £30,000”. The FCA picked £30,000 for a reason. That’s because before the flexibilities you could (and still can) take a small pot commutation – immediately drawing down three small pots of £10,000 for a total of £30,000 – the flexibilities made no difference. In addition, if you had a total pension pots of £30,000 or less, you could take a trivial commutation – immediately drawing down the £30,000 (trivial commutation still exists for DB pots). What the FCA are saying is that, for the vast majority of people who have fully withdrawn their pots, they did so using options that were available to them before the flexibilities (they would or could have done it anyway). The FCA are due to publish their final report later on this year.

So lets get on with it: here are five reasons why drawdown doesn’t deserve the bad press it gets.

1. Drawdown provides total flexibility

Of course, that’s the point. As I’ve noted before, there are four key factors to consider when planning savings and investments: risk, time-horizon, access and affordability. Using drawdown provides a huge amount of flexibility – and therefore access – to your savings. That access allows clients to take money from their pension to make payments they might otherwise not be able to do. Such as meeting debts, paying-off the mortgage or making capital investments in their home or business.

2. Drawdown is the best way to match a retiree’s risk profile

That’s because you can tailor the investment approach in a drawdown fund to meet your attitude towards risk and capacity for loss. We can use the assets left to target growth, income or both. After taking an annuity, your retirement income is, in effect, tied to a gilt-like investment. Whilst suitable for many people, it might not be suitable for those who have a higher risk tolerance and want growth (and not income) from their pension pot. Likewise, long-term investing is the best way to protect against inflation risk. I appreciate that non-crystallised pots would be invested anyway. But we should be conscious that, for many people, there will be a need to access some money on retirement.

We can also plan our investment approach to help with matching time-horizons. For example, we can divide pension assets into three pots for different time-horizons. A short-term pot for paying income over the next year to 2 years. A mid-term pot for balancing income and growth requirements over the 5-10 period. And a long-term pot focused on long-term growth beyond 10 years. Over time, a retiree would move money between pots to balance their assets with their time-horizon requirements and income needs.

3. Expenses aren’t flat and smooth

We may like to think that our living expenses are predictable. But in reality, they are not. Particularly in retirement where there is larger possibility of critical illness or disability. But also for happier reasons, such as: providing for children and grandchildren or doing things that might have been put off due to working full-time. In that respect, drawdown is quite suitable. You draw the money when you need to, and you don’t when you don’t need to. In short: it’s easier to match your income to your expenditure. In addition income requirements typically decline in retirement. As we get older, we spend less. With that the case, a retiree can more comfortably shift their investment focus between income and growth generation depending on their circumstances.

4. Drawdown can help with tax and estate planning

The most important aim with pension decumulation is to have enough income to cover living expenses and support an adequate standard of living level. But that may not be a retiree’s sole aim. A retiree may also want to maximise the wealth they can leave to their family. In 2015, the Government removed the 55% “pensions death tax” with a more favourable regime. This made passing down pension funds inheritance tax-free depending on age of the retiree at death. For more info: https://adviser.royallondon.com/technical-central/pensions/death-benefits/death-benefits-from-april-2015/.

In addition, some retirees will benefit from using drawdown as they can vary the income they take to keep them within certain tax thresholds (i.e. within the tax-free allowance or at nil-rate). We should be careful however, in letting the tax-tail, wag the pensions dog. There is a risk, however unintended, that in trying to cut our tax bill we end up making decisions that harm our most important financial goals.

5. With drawdown you have the money (unless you spend it)

One of the most cited criticisms of annuities is that you “give up” the capital. Whilst I don’t necessarily agree with that wording, with drawdown you keep the capital. It means it’s always there if you need it. Of course, the flip-side is that it’s not there if you spend it. You can have the money or spend it on things. If you buy things, you don’t have the money.

Final words

I appreciate that this article may feel one-sided – rest assured – it is! There are downsides to drawdown. Whether they make sense for you will depend on your circumstances. I’ve not gone into detail on the downsides. It’s very easy to find a lot written about those! And given the evidence so far, a lot of it has been overblown. There are issues with drawdown: we are poor at self-control; we struggle to understand risk; it requires continuing to make investment and financial decisions. That doesn’t mean we should discount it as an option.

I’ll probably aim to wrap this mini-series up with a third post, perhaps  directly comparing annuities and drawdown. But I do want to stress: it’s not an either/or option. Annuities and drawdown can be combined. Potentially, giving a “best of both worlds“. The best decumulation strategy will depend person to person. But both drawdown, annuities or a combination of the two may all provide suitable ways to meet your financial aims in retirement.

 

All the best,

Young FI Guy

Comments

  1. Squandering one’s pension assets via drawdown is, as you demonstrate, apparently rare.

    However, many retirees are simply not financially sophisticated enough (because we are not actuaries?) to work out what a safe drawdown rate is.

    Indeed, our level of uncertainty and variability is far higher (since we must manage the risk of one single life exceeding the assets’ capability to provide income) than that of an insurance company pooling the lifespans of hundred of thousands of clients. In that sense a pooled mutual risk pool is far more “efficient”.

    With drawdown, there are simply unknowable risks of drawing both too much, and too little, income over one’s lifetime. A short-term analysis of the effects of the UK’s drawdown legislation can only tell us that retirees were unlikely to squander their retirement assets — it cannot (yet) tell us about the pensioners whose fear led to them taking less than they could have from their drawdown pots, or those whose over-confidence or optimism led to their taking a half-percent too much each year, and blowing up — analysis of the prevalence of those errors likes some decades in the future.

    1. Hi Jonathan, thanks for a great comment!

      You are quite right that it is very difficult to calculate a safe withdrawal rate as well as to accurately forecast longevity. And all the evidence tells us we are rubbish at it!

      It’s a very strong argument for annuities (as I mentioned in my earlier post).

      I hope you don’t mind, but I’d like to shoe-horn in that the most disappointing element of the flexibilities has been the paucity of available financial advice. The government, and FCA, have done a poor job in getting financial advice available for people. This is a challenging part of finances for people to get their heads around. Unfortunately, the advice gap is growing if anything. And I think the regulator has done a poor job of managing the expectations of clients and how their financial advisor will assess their pension transfers.

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