Should I draw on my pension savings?

• The pandemic-induced lockdown may be easing but it has already inflicted much damage on the UK economy.
• At times like this you could be tempted to raid your pension savings to see you through.
• But we advise caution.

These are worrying times for many. According to Personnel Today, 9 million people in the UK have been put on furlough by the end of June. The Guardian quotes a further 730,000 people have been made redundant so far this year. According to Statista, this has taken the unemployment rate to over 2 million. And things are predicted to get worse. The Independent predicts total unemployment could hit 4 million by the end of the year, quoting data from the Organisation for Economic Cooperation and Development.

The Covid-19 pandemic has seen the global economy slow down and businesses have been forced to close. In the UK alone, it has been estimated by Simply Business that Covid-19 had cost small businesses more than £69 billion by the end of May 2020, with over 230,000 being forced to permanently stop trading. A further 41% of small business owners feared their businesses were at risk of permanently closing due to the pandemic.

At times like this many could be worried about maintaining their basic lifestyle, and could be looking at ways to tide themselves over in the short term.

The temptation

The Money Advice Service confirms that under current rules, anyone over the age of 55 can access their pension savings. The first 25% can be taken free of tax but all other withdrawals are then taxed as normal income. You can choose to take the tax-free amount as a lump sum or as a way to reduce your potential income tax liabilities if taken as part of your regular drawdown strategy.

It is possible to access your pension pots before then but only under exceptional circumstances: for example that you are unlikely to live for more than another 12 months. All other requests can attract a tax charge of 55% of the sum withdrawn.

Nevertheless, the FT reported in April of this year that people looking to withdraw their pensions before the minimum age of 55 had soared more than six-fold in just three months. In March the average age of people asking to withdraw money from their pensions was 35.

Withdrawing money from your longer-term plan might sound like the obvious choice. After all, it gives you more time to pay the money back. And access to a tax free capital sum when you are in financial need can seem too good to be true.

But with pension savings it isn’t that simple.

The potential consequences

Firstly, government rules state that drawing down more than your 25% tax free sum could create an additional tax liability at the end of the year if the additional amount takes your total earnings for that year into a higher tax bracket.

Secondly, and as the World Bank reported at the beginning of August, the Covid-19 pandemic has exacerbated an already slowing global economy and this has been reflected in investment returns. For example, by the end of July the FTSE All share had fallen 20.47% this year. If you had been wholly invested in UK equities and had decided to take the 25% tax-free lump sum, that could mean your pension pot being reduced by a total of 40%. That’s a significant sum.

Lastly, none of us can know with any accuracy when the recovery will come, how strong it will be, and even how long it will last. It could take you a long time to recover back to the level of savings you had at the start of the year.

But I can still make up the difference, can’t I?

That depends on how much you draw down and how long you have until you retire.

Because, as the Pensions Advisory Service warns us, once you’ve accessed your pension savings you can only pay in £4,000 each tax year even if your situation improves and you can afford to put away more than this. So if you withdrew £100,000 you would need to be 25 years from retirement to pay it all back.

How should I approach the situation ?

Whenever we think about our financial affairs, it is best if we consider them ‘in the round’. What are your short-term needs and objectives? That is, what do you need or hope to achieve in the next year or two? What are your medium-term objectives for the next five-to-ten years? And what are you hoping to achieve further out: for example what do you want from your retirement?

Each of these time frames has an associated financial need that we are (hopefully) planning towards. So for example, it is generally recommended to have about three months’ essential spending on hand “just in case”. If we are planning a significant purchase in the next five years (like a car or a special celebration) then it can be a good idea to have this easily accessible too.

Investments (for example stocks and shares ISAs or other investment accounts) should usually be held for 10 years, while our retirement savings are intended to support us through our third age.

And this should be the sequence when it comes to accessing our wealth. Think of your savings first, then your ISAs, then other investments, and your pensions last of all. At a time of record low interest rates, are your bank deposits and other cash savings benefitting you?

And don’t forget, your ISAs can be accessed free of any tax liability. How do I go about tackling my debts?

There may be other ways to alleviate short term financial stress that can avoid withdrawals at all. For example, try contacting your lenders to ask for repayment holidays or see if you can consolidate your loans onto a lower interest rate. Either of these could get you over short-term pressures on your income. Taking an inventory of your outgoings may also identify savings that can be made.

The Money and Pensions Service has a number of articles and resources that could help point you in the right direction. And, of course, talking to a financial adviser could help you gain a better understanding of how different courses of action could affect your financial future.

What if I have no other option than to dip into my pension?

If you feel the funds in your pensions are the only available option you should consider carefully which schemes to withdraw from and/or which funds within those schemes would be least detrimental in the longer term. This can be a complex balance between historical returns, potential future returns, the fees you’re paying to the managers, and how any withdrawals affect the risk profile of your remaining portfolio. Some older schemes might limit your choices entirely.

It’s also important to take stock and fully understand what the withdrawal means for long-term plans and what type of lifestyle the residual funds will support.

This is where talking to a financial adviser can be of particular help.

Conclusion

If you have financial worries, the most important thing you can do right now is to engage with your finances. All of them. Whether that is debt, investments, savings or pensions. The first step to getting on top of your financial affairs is to understand your situation. That means looking at all your financial resources and all your financial obligations. Even going so far as to create lists or columns can help clear your head and look at things objectively. Until you have knowledge you can’t start to take control.

• Can you trim your outgoings without compromising your financial security? That is, for example, without cancelling your protection policies?
• Is there any external help available from your bank(s) and lenders?
• Are there any government initiatives that could support you or your business?

But beware of panic withdrawals from your pension savings. Your decision could lock you into long-term outcomes that might not be appropriate and which could significantly affect your lifestyle in retirement.