Think before dipping into your pension

Increasing your pension withdrawals to help with cost of living rises could lead to financial difficulties later on. Katie Binns explains.

The start of a new tax year is traditionally peak pension withdrawal season, yet data shows higher than normal withdrawals in January and February this year. This suggests investors are leaning on their pensions to help cover the rising cost of living.

The amount interactive investor customers with SIPPs in drawdown typically withdrew from their pensions in January was 25%  higher than the norm for that time of year, while in February it was 7% higher.

Not only are these investors withdrawing more, but they are doing it from shrinking funds. The average value of a SIPP for the over-60s fell 11.6% from a peak of £321,512 at the end of December to £284,230 in mid-March.

Indeed, a period of high inflation presents a major challenge to anyone drawing a retirement income. Inflation is now 6.2% and is set to hit 7% this spring. It could hit 8% later this year.

The problem with inflation for your pension

If you withdraw cash from your pension as the stock market rises, those withdrawals will be partially offset by investment growth. If you withdraw when markets fall, more holdings have to be sold at a lower price to provide the same level of income.

That means that the value of your pension shrinks more quickly and you are dependent on greater investment growth in the future to make up the losses.

And the problem is made worse by inflation. Most of us want our pension withdrawals to increase in line with inflation to keep up with rising prices and maintain our living standards. However, if inflation runs hot for an extended period of time, this will have a big impact on the sustainability of a withdrawal plan.

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For example, someone with a £300,000 pension pot who wants to take an annual income of £11,000 from age 65 (after taking their 25% tax-free lump sum) and whose pot generates growth of 3% a year, might run out of money by age 86. If their pot fell in value to £270,000 in the first year and they took the same income, it might run out by 84 instead.

If they had to increase their income to £12,000 a year on a £270,000 pot, their income could run out at 82. However, if, in response to the fall in the pot value, they took out £10,000 a year instead, their pot would last until age 86.

Becky O’Connor, head of pensions and savings at interactive investor, says: “Retirees are facing dilemmas over whether to take out more cash from their pension pots to cover rising living costs. The impact of inflation means that not only do they need to withdraw more money to pay bills, the pot is itself being eroded in value – a ‘double depletion’ effect.”

What you can do

Our example shows that taking less from your pension helps. So taking as little from your pension as you can is a no-brainer.

“People need to redraw their drawdown plans for straitened times. A year ago, plans to use some cash from your pension to pay for a new car or home renovation plans might have seemed reasonable,” says O’Connor. “Now, you might need to look with fresh eyes at any spending you don’t need to make, which might place your future retirement income in jeopardy.

Conversely, anyone planning to increase their withdrawals to maintain their spending power during the current period of high inflation should think about the impact of doing so on the sustainability of their plan. Inflation affects us all differently, so it might not affect you as much as others. There are online calculators that allow you to work out your real rate of inflation.

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If you can, try to delay withdrawals until a point where markets are rising again – or at least when values are not falling. If inflation and market falls persist and your pension looks set to erode even more quickly than planned, be ready to consider further action such as cutting out certain aspects of your lifestyle and reducing planned inheritances. Inflation is unfortunately entirely out of our control.

However, the Bank of England expects inflation to fall back over the next couple of years, so you can at least look forward to the easing of pressure on your pension pot value in the not-too-distant future.