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You’ve spent your working life building up your savings. Hopefully making the most of the tax incentives pensions have to offer and compound returns over the long term. But retirement is the point where the impact of financial decisions can actually start to compound in reverse, if you take a wrong turn.
Here are five common pension pitfalls that could derail even the best laid plans. Avoiding them will give more control over your income in retirement and how long your money might last you.
1. Underestimating the likely cost and length of retirement
According to the Office for National Statistics (ONS), a 50-year-old man in the UK today has an average life expectancy of 84, and it’s 87 for females. Nobody knows exactly how long they are going to live for, but these estimates suggest that most people should expect their retirement savings to have to last them for around 30 years.
Underestimating how long you’ll live, perhaps due to your family health history, could mean you run out of money too quickly and be forced to survive on the state pension alone, which might fall very short of the lifestyle you’d hoped for in retirement.
It’s also important to factor the cost of living into your figures, in other words, how inflation might impact your purchasing power over time. The state pension currently benefits from triple lock protection, but you’ll need to think about how you plan to support yourself if you’re planning on winding down before you claim it.
2. Assuming you need to take all your tax-free cash at once
Being able to take a 25% tax-free lump sum from pensions is widely recognised as one of the big pension perks, but many people either take their full 25% tax-free cash upfront because they think they have to take it all at once or take it simply because they can.
If you don’t need the cash immediately, it might make better financial sense to access your pot in stages. You could do this by moving regular sections into drawdown – sometimes called phased or drip feed drawdown, or by taking ad hoc lump sums, officially known as uncrystallised funds pension lump sums, or UFPLS. Whatever you leave invested in the pension wrapper can continue to grow tax-free, which means the value of your total tax-free lump sum can also grow over time.
Let’s take the example of Nancy who has a £100,000 pension pot. Nancy could take up to £25,000 tax-free cash and the remainder moves into drawdown from where she can take a taxed income when she wants. She cannot take any more tax-free cash from that pension. But if Nancy doesn’t need all the tax-free cash immediately, she could access just £20,000, £5,000 will be paid out tax-free and £15,000 can move to drawdown. That leaves £80,000 untouched and continuing to grow, meaning her next slice of tax-free cash could be more than £20,000 (25% of £80,000), giving her a higher total tax-free cash amount overall.
Only withdrawing what you need will help your pension last longer and could help you manage your tax position more efficiently over time.
3. Triggering a lower pension allowance when you’re still working
The Money Purchase Annual Allowance (MPAA) applies when you take a taxable income using one of the flexible options, such as drawdown, or an uncrystallised funds pension lump sum (UFPLS). The MPAA doesn’t apply to any defined benefit pensions you hold or if you use your fund to buy an annuity in most cases.
Once triggered, your annual allowance for defined contribution pensions drops to £10,000 each year. You’ll face a tax charge on any contributions over the allowance, and you’ll also no longer be able to use carry forward for your defined contribution pensions, which can limit your ability to rebuild pension savings if your plans change.
If you are still working and plan to continue paying into your pension, or you’re returning and might be auto enrolled, you might consider avoiding taking taxable income until you are sure you will not need higher contribution allowances.
4. Not matching your investment mix to your goals
This can be both in the run up to accessing your pension and if you’re already taking an income from your retirement pot.
You might run into problems if your investments and retirement plans are not aligned. For example, if you’re invested heavily in shares or equity funds, but you plan to turn all of some of your pot into a secure income by purchasing an annuity very soon, you’re leaving yourself exposed to short-term market volatility.
On the flip side, you might discover your workplace pension is invested in a lifestyle fund or one that is targeting annuity purchase in the coming years when you actually plan to move your funds into drawdown when you access your pension.
As we highlighted at the start, your pension might need to last you 30 years or more, and a de-risking approach simply won’t stack up against inflation and withdrawals, running the risk that you outlive your savings.
History shows that being invested give you the best chance of beating inflation over the long term, but short-term market fluctuations can impact retirees who are withdrawing from their investments. The danger of having to sell your investments to withdraw income when markets are falling is sometimes called ‘sequence risk’. Most people are familiar with the benefits of compound returns when it comes to growing wealth, but withdrawals in downturns can work the opposite way, effectively locking in losses which could make it difficult for your portfolio to recover or mean you run out of money sooner.
You can mitigate sequence risk by holding short-term planned withdrawals in cash or cash-like assets, and medium-term ones (three years plus) in income-generating investments. The rest of a drawdown portfolio might be allocated to shares or equity funds, that aim to give you a real return over and above the rate of inflation in the long term.
Setting up a cash ladder or using cash like investments to help fund your planned withdrawals in the early years can help to mitigate some of this risk. It can give your invested portfolio time to recover before restarting withdrawals or even prevent you having to pause withdrawals in the first place.
5. Being caught out by HMRC’s emergency tax rules on withdrawals
Despite improvement to the tax code process for pensioners setting up regular drawdown income, the emergency tax and reclaim process remains a thorn in the side of anyone looking to make the most of pension freedoms with ad hoc withdrawals, as and when they need them.
Figures show that pensioners have actively reclaimed almost £1.6 billion in over taxation in the 11 years since pension freedoms began in 2015. But this doesn’t include many more people who’ve either chosen not to use HMRC’s forms or are unable to because they are already in the self-assessment system.
If you’re planning to take a single taxable withdrawal, one way to potentially avoid the shock of a big over taxation bill is by taking a small, notional withdrawal first. This should mean HMRC sends your pension provider the correct tax code to apply to the second, larger withdrawal. Otherwise, you’ll have to fill out one of three HMRC forms to help you receive overpaid tax back within 30 days. If you don’t do this, HMRC says it will put you back in the correct tax position at the end of the tax year.
Charlene Young: Senior Pensions and Savings Expert
Charlene Young is AJ Bell’s Senior Pensions and Savings Expert. She joined AJ Bell in 2014 from a wealth management firm where she worked with private clients and small businesses as a financial planner.
Charlene...
