Income drawdown involves drawing an income directly from your pension, subject to a maximum set by the government, called the GAD rate which is driven by gilt yields. To consider income drawdown rather than buying an annuity from an insurance company, you really need at least £50,000 in your pension fund and preferably £100,000.
Savers using income drawdown have been given a new year boost as the GAD rate once again hits 3.25 per cent for January 2014, up from 3 per cent in December 2013. Calculations made by LV= show that the new GAD rate will allow a 65-year-old client with a pension fund worth £100,000 to take £7,320 in income rather than £7,080.
One reason to use income drawdown is to delay annuity purchase. Annuity rates have started rising - Moneyfacts reports that 2013 was a record year for annuity rates with the average annual income payable from a standard level without guarantee annuity for a 65-year-old based on a £50,00 purchase price rising 10.5 per cent during the year.
If this trend continues, today could be a bad time to buy an annuity. Over 2013, investors who went into drawdown and delayed purchasing an annuity could have earned a low risk 15 per cent from a combination of a cautious investment strategy and the rise in annuity rates, according to James Baxter of Tideway Investment Partners.
But investors may also want to delay annuity purchase in order to secure a better deal in later retirement as their health deteriorates.
For most people retirement comes in three stages with different financial needs, and a fixed rate annuity may not be the best way to meet all three.
Stage 1: Typically 55-70
Retirement is mixed with part-time work. You may be spending lots of money on your lifestyle needs such as going out for meals, entertainment and holidays. But if you are still earning an income, you may not find this is such a drain on your finances.
Stage 2: Typically 60-85
You are fully retired without an income from work. However, this is a period of 'independent' retirement when you are still in relatively good health and still spending the same money on having a good lifestyle. So you might find that you need to dip into your finances more.
Stage 3: Typically 85-plus
You are in 'dependent' retirement, needing some degree of health or personal care, which may be expensive. However, your lifestyle and entertainment spending may have dropped.
Income drawdown can offer the flexibility to deal with all three stages.
For married couples there may be a further stage - the cost of providing an income for the surviving spouse. The cost of providing a survivor's annuity, called a joint life annuity, is often 20 per cent more than a single life, level annuity.
But under income drawdown, a survivor's income can be provided without cost, as the pension pot can continue providing income after your death. Alternatively, your spouse can purchase an annuity based on her own older age at the time you die, which will probably result in a better deal than taking out a joint life annuity at the start of retirement.
However, at whatever stage you are considering drawdown, first find out what the best annuity would provide so you have the true comparison. Brewin Dolphin has found considerable disparities between the best and worst annuities quoted for a typical 65-year-old single male with a £300,000 pension pot. An amount of £3,391 a year (£17,769 vs £14,378), which if he lives a further 18.3 years, equates to £62,000.
Also, consider if you can truly stand the investment risk associated with drawdown.
When you're drawing income via drawdown, think about three main time horizons and divide your pension pot accordingly.
1. Short-term income pot - your investments are liquid and safe, ensuring the income is paid next year, or the year after that.
2. Replacement income pot - your investments can be a bit more volatile.
3. Long-term investments - here you have the chance to benefit from equity exposure.
However, make sure you understand that the dynamics of taking money from an investment fund are the reverse of putting money in on a regular basis.
Returns on a fund from which you are taking regular withdrawals will be fantastic if prices rise steeply at the beginning of your investment period and then remain steady or gently rising in the later years. However, in drawdown you are running the risk that if there is a stock market crash in the early years of withdrawal, this could work out badly for your long-term income prospects. Stock market recoveries are often not enough to recover the funds for those taking heavy withdrawals from their investments.
