In simple terms, a flexi-drawdown pension is an arrangement that allows you to withdraw funds from your pension savings as and when required. The balance of the pension funds remains invested. The intention is to provide long-term capital appreciation and additional funds to draw down in the future. Introduced in April 2015, flexi-drawdown pension arrangements have proven very popular.
Before we look closer at the flexi-drawdown process, it is worth reminding ourselves of the previous setup. As a means of simplifying pension regulations, the new flexi-drawdown option effectively merges the previous options. These were:
There was a degree of flexibility with capped drawdowns regarding when and what you could withdraw from your pension. However, the level of withdrawals was capped. Under regulations at the time, the maximum annual income you could withdraw was no more than 150% of what you would have received if you had bought an annuity.
Many people confuse the flexible drawdown option with the flexi-drawdown option; these are very different. To utilise the flexible drawdown option, you would have to receive a pension income of at least £12,000 a year from other sources. The idea was simple, as you were already in receipt of more than £1000 a month pension income, you could tap into the additional funds as and when required.
The pension regulations announced in April 2015 meant greater flexibility for pension fund holders going forward. However, there was also a subtle withdraw from the historic annuity link after rates sank to all-time lows.
Do all pension schemes qualify for a flexi-drawdown pension arrangement?
It is essential to realise that not all pension schemes will qualify for a flexi-drawdown pension. There are several conditions to consider, which include:
To qualify for flexi-drawdown, you must be aged 55 or over. You may need to revert to the terms of your pension fund and how it is managed to clarify your situation.
A flexi-drawdown pension arrangement is only applicable to defined contribution pension schemes, otherwise known as money purchase. These are schemes in which you contribute with no absolute guaranteed value. However, upon retirement, you can acquire an annuity, defer your pension or activate the flexi-drawdown pension option.
Withdrawing funds under a flexi-drawdown arrangement
Whether you decide to withdraw funds from your pension arrangement at the earliest opportunity or defer payment until a later date, this is your choice. There are two different types of pension income to consider which are:
Tax-free lump sum
When you become eligible to withdraw funds from your pension scheme, you will have the option to take what is known as a tax-free lump sum. This equates to a maximum of 25% of your pension fund on which there will be no tax payable on receipt. For many people, this is the first stage of a flexi-drawdown pension arrangement.
It is worth noting that you don’t need to take the 25% tax-free lump sum in its entirety. Instead, you can stagger the tax-free lump sum payment over time. As long as the payments remain within the 25% limit, there will be no tax charge.
Due to the nature of the pension flexi-drawdown arrangement, you can decide to withdraw funds in the future, as and when required. Many people prefer to set up regular pension income direct debits. However, this does not stop you from making additional withdrawals. The idea of the pension flexi-drawdown option is that remaining funds can be reinvested for the long term, with potential for further capital growth.
Note that any discretionary payments beyond the tax-free lump sum limit will be added to your annual income with the appropriate rate of tax charged. The discretionary nature of these payments may help to avoid moving through upper tax rate thresholds in any one tax year.
Pros and cons of flexi-drawdown pension payments
The flexible nature of this new type of pension payment has been appreciated by many. However, there are some pros and cons to consider.
Pros of flexi-drawdown pension payments
Firstly, we will look at the pros of flexi-drawdown pension payments:
Timing of payments
Whether looking at lump sum tax-free payments, staggered payments or discretionary income payments, you are in complete control of the timing once you qualify for your pension. As more people now work longer, it may serve you best to delay taking your pension while receiving working income. However, additional funds via your pension scheme will be available as and when required.
Investing for the future
In the old days, acquiring a pension annuity guaranteed a fixed income for the rest of your life. When annuity rates were much higher, this made perfect sense for many people, long-term income with no risk to capital. However, prompted by a long-term reduction in annuity rates, the flexi-drawdown income option allows remaining funds to be invested for the long term.
Many people tend to take a more cautious approach to their investment strategy in later life. This helps ensure a greater degree of certainty concerning pension fund assets and potential payments in the future. However, should you wish to acquire an annuity further down the line, the option will always remain. Therefore, it is essential to take professional financial advice regarding your investment strategy and security of income going forward. For example, does your investment strategy match up with your future income requirements?
Adjusting future payments
Even today, despite a long-term reduction in rates, many people still consider acquiring an annuity. Annuities offer fixed income going forward and a degree of stability for many people. However, you will have no control over future payment levels. It is very different when it comes to flexi-drawdown withdrawal arrangements.
You may decide to set up a monthly direct debit for a fixed amount. In the future, you may choose to withdraw one-off payments or even increase/decrease the monthly direct debit amount. The point is that you have complete discretion when adjusting future payments. For example, it may be that your pension fund has performed exceptionally well, and you can afford to take a little extra regularly. Consequently, you may be forced to rein in your spending if the investment performance has been disappointing.
Nominees and future payments on death
Before 6 April 2015, only dependents or spouses of the deceased were eligible to receive future pension fund payments from their pot. However, while dependents and spouses still receive most drawdown payments, there is now the option to appoint a nominee. This nominee could be an individual, company or charity who would receive future drawdown payments from the pension fund. It seems that the authorities have finally realised that individuals are entitled to more freedom of choice.
Cons of flexi-drawdown pension payments
It is not difficult to be blinded by newfound freedoms concerning your pension assets. However, there are still some issues to be wary of:
Longevity of your pension fund
Historically, those who acquired an annuity knew how much they would receive each month for the rest of their life. The figures were based upon average life expectancy, offering a relative degree of certainty to insurance companies when making these calculations. However, the situation is very different when it comes to flexi-drawdown pension payments.
With the stability of an annuity taken away, you may find that your pension fund does not last as long as you had hoped. Consequently, you may run out of pension funds before your death, which could severely impact your income and standard of living.
The value of your investments can go down as well as up
While long-term investment gives you an excellent opportunity to create long-term capital appreciation, this is not always the case. If we consider the initial weeks after the discovery of Covid-19, this perfectly illustrates the investment challenges many people faced. The following graph shows the performance of the FTSE 100 index from the first rumours regarding Covid-19 to July 2021.
Image Credit: GroupEditor
Those planning to retire in 2020 saw a considerable drop in the value of their stock market-related pension assets in the first quarter of the year. Even though markets have recovered, the FTSE100 is still shy of the previous high before the pandemic. While we live in unprecedented times, this reflects the uncertain nature of remaining in potentially volatile investments while drawing down income from your pension fund.
There are more secure investments such as gilts and various high-grade bonds. While there will be limited capital appreciation with these types of investments, they can offer an attractive level of income. As we touched on above, it is vital to adjust your investment strategy as your requirements change.
One restriction to be aware of when you enter flexi-drawdown is a reduction in allowable pension contributions. Before crystallising your tax-free allowance, you can contribute up to £40,000 per annum into your pension scheme, dependent on your income. However, once your tax-free allowance has been crystallised, you will then be subject to the money purchase annual allowance of just £4000. This means that you can only contribute £4000 a year to your pension without attracting charges.
Some people may question making contributions to your pension scheme just before your retirement. However, to appreciate this, we need to consider that the government will gross-up any pension contributions, effectively repaying income tax. So, when managing your pension assets or contributions, a reduction from up to £40,000 a year to £4000 a year may be significant.
Pension freedoms need to be respected
Even though the UK government has been criticised for introducing an array of new pension freedoms, all they have done is put control back in the hands of pension fund owners. The onus is still on individuals and their financial advisers to "do what's best for them". It is essential to take a long-term approach but also adjust your investment strategy as you advance towards retirement. These regulatory changes are still in their relative infancy; therefore, the full impact may not be known for some years.
Is flexi-drawdown the right move for you?
While the flexibility of the new drawdown arrangement has been well received, this increased flexibility comes with a need to undertake a more cautious approach to investing. When you have 20, 30 or even 40 years to retirement, you can take a more long-term view of your investments and potential capital appreciation. When you are about to enter retirement, you might prefer a greater degree of stability. Consequently, many people may switch to gilts and bonds to protect their capital while maintaining a degree of income.
It is essential to take professional financial advice as you enter pension withdrawal territory. There are many rules and regulations to consider and numerous options to discuss.