INCOME DRAWDOWN IS ONE OF THE MOST FLEXIBLE retirement options available, but it is also more complex and higher risk than an annuity. It is effectively a way of providing your retirement income without sacrificing control over your investments. Your retirement fund will continue to be invested and any retirement income you decide to take will come directly from your fund, and there is no need to draw any income – making it an attractive option for people who need to access their tax-free cash to meet a capital expense, but do not require the taxable income which would be provided by an annuity. Income drawdown also provides flexibility about how and when you receive retirement income. You can use your fund to purchase an annuity at a later date when this is more appropriate for you. The death benefits available through an income drawdown pension are more flexible than through an annuity. This flexibility comes at the expense of ongoing charges and continued investment risk. An income drawdown plan does not normally provide a guaranteed income for life; by remaining invested your income could potentially increase, but if your investments do not perform as expected your income could reduce or in extreme circumstances stop.
Pension freedom
Under the new pension freedom rules, all the limits on how much money you can withdraw from your pension have been removed. You can draw out your whole pension fund in one lump sum if you wish. This is not usually a good idea as you have to pay income tax on the withdrawal (excluding the 25% taxfree lump sum). In order to calculate the income tax due, the withdrawal is added to your annual income which can mean you pay tax at the 40% (or even 45%) rate, even if you are usually a basic rate taxpayer. If you are considering drawing money from your pension, it’s really important to seek advice to ensure you do not face an unexpected tax bill and you have enough money to live on throughout your retirement.
Many people underestimate their life expectancy, which means they risk running out of money in old age.
Death benefits
If you die with funds left in your income drawdown plan, the death benefits
available to your loved ones will depend on whether you were 75 or over.
Before 75
- Any beneficiary can inherit the remaining fund as a taxfree lump sum.
- A dependant can continue with drawdown or use the fund to purchase an annuity. They will not usually be taxed on this income.
After 75
- Any beneficiary can inherit some or all of the fund as a lump sum. The inherited fund will be added to their own income and taxed at the appropriate rate.
- A dependant or beneficiary can continue to draw down income or purchase an annuity and pay tax at the rate applicable to them.
Choosing investments
Where you choose to invest may depend on your strategy for taking income – whether you’re investing for income, investing for growth or drawing capital from your pension. A popular way to draw income is to only take the income generated by the underlying investments such as the dividends or income from shares, funds or corporate bonds. This is known as taking the “natural yield”. Alternatively you could sell investments to create cash for withdrawals, known as “drawing on capital” – this, however, will cause the value of your pension to fall over time if your withdrawals exceed the amount by which your pension grows. How your investments perform will impact on how much income you can withdraw sustainably and how much is left in your pension to pass on.
Pros and cons
Pros
- Timing – you can choose when to purchase an annuity and may be able to benefit from improved rates.
- Flexibility – you can vary the amount of income you take and potentially control your income tax liability.
- Investment control – you can continue to make investment decisions with regard to your attitude to risk and investment needs.
- Death benefits – you can leave your fund to nominated beneficiaries
Cons
- Timing – annuity rates may worsen rather than improve, or may not improve sufficiently to make up for years in which you have not received this income.
- Mortality drag – annuity rates take into account the fact that some people will die earlier than statistically expected (this is called mortality cross subsidy). If you use income drawdown to delay purchasing an annuity, the effect of mortality cross subsidy will be reduced and you would need to achieve a higher return while in income drawdown to counteract this (this is known as mortality drag).
- Investment risk – the value of your fund is not guaranteed and may go down as well as up. The value may not grow sufficiently to provide an income that matches that which you would have secured by purchasing an annuity.
- Income – high income withdrawals are likely to be unsustainable and this may reduce the financial security of you and your dependents in the long term.
- Review – your fund and investment selections will need to be monitored and reviewed periodically to ensure investment performance remains on track.
- Charges – your fund will be subject to charges to cover administration and fund management. These are likely to be higher than a standard personal pension as the policy must be reviewed regularly and income payments administered. Please note that this article is not personal advice. Drawdown is considered a higher risk option than an annuity; if you are at all uncertain about its suitability for your circumstances, seek advice.
