Pension Income drawdown especially post 6th April 2011 is one of the most flexible retirement options available but this does make it more complex. It offers potential for growth and allows you to retain control of your money, as well as an opportunity to pass your pension fund on to your heirs. Yet there are big drawbacks and risks.
The UK financial regulator, the Financial Services Authority (FSA), regards pension income drawdown as a complex product and strongly recommends that pension members seek professional advice about it.
This information will be of particular interest if you:
- are approaching or have reached retirement age
- are considering drawing an income from your pension fund instead of buying an annuity
- have substantial assets to provide an income in retirement
- are prepared to take some risks with your pension fund to achieve greater flexibility and a potentially higher return.
Pension Income drawdown is an alternative to buying a lifetime annuity. It allows you to draw an income directly from your pension fund, whilst the fund remains invested.
On transferring to an pension income drawdown plan, you can immediately take a tax-free lump sum of 25% of the fund value and then take an income from the invested fund up to a limit prescribed by the Inland Revenue.
In some instances you may be able to obtain more than 25% tax-free cash from some occupational pension schemes depending on your length of service and salary. It is not compulsory to take any tax-free cash and you can take less than 25% if you wish. However, the tax-free cash must be taken at the time that the plan is set up.
Unlike an annuity you do not have to take any income. The maximum annual income that you can take is set by the Government Actuaries Department (GAD). You can, therefore, take any level of income between zero and the maximum on a yearly basis. You can vary this income at any time, meaning that one year you could take nothing at all and the next the maximum.
Every three years this maximum level has to be reviewed and can increase or decrease depending on a combination of the fund value, your age and the GAD rate at that time. It is also possible to request annual reviews at the discretion of your pension administrator/trustee.
Investment of your funds
The pension fund that remains after taking tax-free cash is invested in any investment fund that is offered by the provider of the plan. These funds are likely to cover all investment markets and will include both funds managed by the provider itself and also external funds such as unit trusts. These funds will cover all investment classes, i.e. UK equities, both growth and income, overseas equities, commercial property, fixed interest, corporate bonds and gilts. The funds can be changed (switched) between any of the funds that are available and with many providers at no cost.
Therefore the selection and managing of your investment funds within the Drawdown plan is just as important as selecting the right plan and provider at the outset.
Before investment funds are recommended your “Attitude to Investment Risk” is ascertained, which would determine whether you were a Cautious or Adventurous investor, or anywhere in between.
One of the most attractive features of pension income drawdown is that it allows you to retain control of your investments. You continue to manage and control your pension fund and make all the investment decisions. Providing the fund is not depleted by excessive pension income withdrawals or poor investment performance, it may be possible to increase your income later in life. However, it is important to remember that fund values can fall as well as rise in which case your income would also drop.
If you die whilst in pension income drawdown the remaining fund can be passed on to your heirs, less a 55% tax charge, or can be made available to provide an income for your dependants.
Contracted out pensions require that an income is made available for a surviving spouse or civil partner. This can be either via an annuity or income drawdown. Only where there is no spouse or civil partner may the fund be passed to another nominated beneficiary.
You can use your income drawdown fund at any time to buy a lifetime annuity. If you want to continue drawing an income directly from the fund indefinitely.
At first glance, pension income drawdown might appear a saviour to those worried about the inflexibility and limited death benefits offered by annuities. However, with the benefits come risks that you must be aware of. In the worst case scenario your pension fund could be massively eroded meaning you have little or no private money to live on in retirement. It is therefore only a consideration if you are in a position to accept these risks.
How does pension income drawdown work?
Firstly, you decide how much of your pension fund you want to move into pension drawdown. You can then normally take up to 25% of this as a tax-free lump sum and draw a regular income from the rest. There is no minimum withdrawal amount so you could choose zero income if you wish.
Any income is subject to tax at source, on a Pay As You Earn (PAYE) basis. You decide where the remainder of the fund is invested, and you should review and monitor the situation regularly.
The maximum income you can draw can be more than the income from a level, single life annuity bought using the same fund. The maximum is calculated at the start of your pension drawdown plan using government actuary department (known as GAD) tables which use your age and 15 year gilt yields to calculate the income available from your fund. The income limits calculated at this point are fixed until the next review.
If you smoke, or suffer from ill health, an annuity income could be higher than the GAD limit allowed under pension income drawdown, as the GAD calculation does not take health or lifestyle into account.
As long as you stay within the maximum limit you can control how much income you take, and when you take it. At least every three years the income drawdown provider is required to review your plan and recalculate the maximum annual amount you can withdraw from your income drawdown plan. This is known as the reference date. After each review the provider will tell you the new annual GAD limit, which could be lower or higher than the limit from the previous review or reference point.
It is usually possible to combine pension income drawdown with an annuity by splitting your fund. One section of your pension can be used to buy an annuity, providing you with a secure income to cover your essential living costs. The remainder, which you could afford to take more risk with, can then be placed into pension income drawdown to provide a flexible additional income to supplement the annuity.
PENSION INCOME DRAWDON - ADVANTAGES & DISADVANTAGES
Advantages
- Access to tax-free cash immediately
- Flexibility to vary your income according to your requirements
- Control the level of income tax you pay
- Control of your investment
- Funds benefit from investment growth in a tax-efficient environment
- Choice not to purchase an annuity
- Choice of death benefits for dependents
Disadvantages
- Future investment returns are not guaranteed
- Annuity rates may be lower in the future (if purchased)
- High withdrawals of income may not be sustainable
- The higher the level of income withdrawal chosen the less that may be available to provide for dependants
- Increased flexibility brings increased administration costs
- The level of income may change due to the 3 year review
WHO MIGHT CONSIDER PENSION INCOME DRAWDOWN ?
Income drawdown is complex and in our view it is not suitable for everyone. We believe there are two main groups you could belong to if you are thinking of taking benefits through pension income drawdown. These are detailed below.
GROUP A
You have built up pension funds that are your primary source of income in retirement
Your pension funds are your main means of providing retirement income. You have decided you want to take your tax free cash and start drawing an income.
However, rather than buying an annuity you wish to take out pension income drawdown. If you fit in this group of people it is vitally important that you try to preserve the value of your pension fund. You can afford to expose your pension income to some risk, but are likely to adopt a more cautious investment strategy than investors in group B. People in this group who are considering pension drawdown will tend to have a pension fund of at least £150,000, before taking tax free cash.
GROUP B
Your pension fund is not your only significant source of retirement income
You have built up a pension fund that you want to put into pension drawdown. This is not your only significant source of retirement income - you have other pensions or investments to fall back on. You are aware that you could lose all your money in the worst case scenario. However, you can afford to take a greater degree of investment risk.
Whichever group you fit into, you must understand the biggest risk of pension drawdown. This is that your fund could be significantly eroded in adverse market conditions, or if you make poor investment decisions. This in turn will lead to a lower (perhaps no) income in retirement.
If you are in group A then you need to take far more care in your decision to go into pension income drawdown and seriously consider whether an annuity would be more appropriate for at least part of your retirement income. Anyone considering pension drawdown needs a significantly more adventurous attitude to investment risk than someone buying a lifetime annuity.
Lower-risk investments may struggle to keep pace with the income you withdraw, while higher risk investments could mean the capital will be subject to large fluctuations. The investment returns may be less than those shown in your personal illustration.
You could consider a well diversified portfolio of assets such as:
• Cash - to pay the income in the early years.
• Fixed interest - to generate income and provide diversification from higher risk investments.
• Equities - for high potential long term returns through both capital growth and dividend income.
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