How Pension Drawdown Works

By: Tim Bennett
Tim Bennett sheds some light on a key choice facing retirees under the pension freedom rules.
The decision about how best to generate an income in retirement is a complex one for many retirees. Here we take a quick look at where the drawdown route fits in.

Accumulation versus drawdown

The lifecycle of a pension can be broken down into two stages as follows;
Here we are focusing on the second phase on the right – having built our lifetime savings pot whilst working, how can we ensure that it will meet our retirement needs? The answer depends, in part, on what sort of pot you have accumulated.

Sources of retirement income

These days a retirement income could come from a number of sources;
Whilst State Pensions and Defined Benefit (or Final Salary) schemes provide a more-or-less guaranteed income, personal pensions and non-pension assets do not. Under relatively recent changes to the rules, you now have far more flexibility about how you use a private pension pot.

So, assuming you elect not to hand over your money to a life assurance company in return for an agreed income (an annuity) having taken your 25% tax-free lump sum, how does the drawdown route work? The answer is complex so here is a simple example.

Let’s say you have a £200,000 pot on retirement. Your options could be summarised as;

  • Living off capital
  • Living off income
  • Living off a mixture of the two

For many retirees the last route will be the most likely, since a pure cash-based capital-only solution is likely to be too cautious and an income-only route may not provide enough annual funds in a low yield world. The key question then becomes – how much can I afford to draw down on a mixed basis so that my pot lasts long enough?

The answer depends on several factors, including the number, size and timing of any one-off large capital drawdowns in the future and the overall growth rate you achieve on your invested capital. Over a chosen 30-year period, this growth rate will affect your annual drawdown as follows;

So, at a 2% rate of growth you could afford to drawdown nearly £9,000 versus more like £11,500 at 4%. On a capital-only basis, with no adjustment for inflation, you could drawdown around £6,600. Clearly, the length of the chosen drawdown period will heavily influence the drawdown rate and also the impact that inflation has on both your income and remaining capital sum.

Balancing up your needs

A successful drawdown strategy will take account of both your need to generate an income and also meet specific retirement goals. For example if your aim is pure income, then an equity-based portfolio will tend to be the more effective route. However if your aim is certainty and predictability regarding both the amount and timing of future cash flows then a bond portfolio may be the better bet. Many investors will want to blend the two approaches to achieve the right outcome. In short then there is plenty to think about when it comes to managing a portfolio in drawdown and balancing you cashflow requirements over the course of a fulfilling and enjoyable retirement.
To find out more about any of the points here please contact an Investment Manager.