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Retirement: Income drawdown

Created:
30 March 2007
Written by:
Dominic Picarda

So, you've amassed a tidy sum in your Sipp or personal pension thanks to your wise investment decisions. Now you have another equally important choice to make: should you use all your pension pot to buy a steady income from a life insurance company, or should you keep your investments going and live off them directly by drawing down some income?

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The idea of income drawdown - or an unsecured income, as this approach is also known - may instinctively sound much more appealing than buying an insurance company annuity. If you keep your Sipp going, the assets within it can continue growing. And there's always the possibility of passing the remaining funds on to your heirs after you're gone. By contrast, an annuity dies with you - and the life insurance company gets to keep all that hard-earned money you used to fund your annuity purchase.

The lowdown on drawdown

Understandably, many people are upset by the thought of paying over the fruits of many years' prudent saving only for the life insurance company to keep the lot if they're unlucky enough to die early on in their retirement. The pill has become more bitter still in recent years, as increased life expectancy and falling interest rates have reduced annuity rates dramatically.

Even so, as unfortunate as the annuity situation is, it doesn't present an automatic case for choosing income drawdown. Drawdown has disadvantages of its own, which could make it totally unsuitable for your particular circumstances. Many people fail to get to grips with its complexities and risk ending up much worse off than had they bitten the bullet and bought an annuity.

Having sufficient assets is obviously a key factor in whether or not you should opt for income drawdown. To be on the safe side, it's advisable to have a lot of money inside and outside your Sipp, as well as a back-up. Ideally, one might have £250,000 in the Sipp, as well as substantial savings in individual savings accounts (Isas) and personal equity plan (Peps). Alternatively, you might have an occupational pension scheme or a separate portfolio of investments to help out here.

"To do drawdown, you need to have quite a bit of money outside pensions," says Mark Dampier, head of research at Hargreaves Lansdown. "If you haven't got that, I'm not sure if you should do drawdown at all. I was appalled by the amount of people in Equitable Life who were told to do drawdown with about £100,000 and who clearly didn't have much money outside that."

Your likely longevity also has a huge bearing on whether an unsecured pension is suitable for you. Contemplating the timing of one's own death is always a problematic and unenjoyable exercise. However, the logic is clear enough: those with a significant chance of dying earlier on in their retirement may do better with income drawdown, as it allows for the pension assets to be passed on to dependants.

And there are certain circumstances in which the prospects of longevity are easier to work out than is normally the case. An obvious instance is where a retiree is in generally poor health or is suffering from a serious illness. Family mortality patterns are also helpful in determining possible remaining lifespan, although it may only be possible to draw reasonably firm conclusions in a minority of cases.

As with an annuity, though, you're still a hostage to the state of the markets when you start income drawdown. In a bull market, a retiree will see his remaining shares rising, helping to offset the depleting effect of his drawing an income from them. In a bear market, though, there's a double-whammy, as an investor draws down income from an equity portfolio that's already shrinking as share prices fall.

How to proceed

Suppose that, after in-depth consultation with your advisers, you decide that drawdown is the way forward for you. The next big issues are how you much you should draw down and how to manage the assets during your retirement. At the outset, you have the option to take a tax-free lump sum amounting to 25 per cent of your fund's total value, so you could use this in order to make some of your income tax-free.

How much can I draw down?

You don't have to draw a fixed amount every year - you can take from anything between nothing and the maximum allowed. The government imposes an upper limit so as to prevent people from drawing down too much and then ending up with nothing to live on. How much you're allowed to take is decided by a calculation based on your age, the value of your assets and the 15-year government bond yield.

To see this in action, consider a Sipp investor retiring today at the age of 65 with £200,000 in his pot after taking his tax-free lump sum. With the 15-year gilt yielding 4.71 per cent, the Government Actuary department tables enable us to work out that the maximum amount that could be drawn each year is £14,400. This figure then has to be reviewed at least every five years thereafter.

How much you are allowed to take after subsequent reviews will, of course, depend on your investment performance. If you make bad decisions - or if the asset classes in which you are invested do badly - then clearly there is a risk of being left unable to draw down what you need each year. This is precisely the situation where a back-up source of retirement income would be called for.

How to structure drawdown

Once you know how much you want or are able to draw down each year, you are in a better position to manage your assets so they can meet the required cash flows. There's no automatic solution on offer when it comes to the business of actually allocating your assets. As before, the particular objectives of a retiree will determine the path taken.

But, faced with a planned series of liabilities - the payments you intend to make to yourself at whatever intervals - one approach is to structure your holdings in order to match these as closely as possible. And having a fixed-income portfolio whose coupons and maturity payouts coincide with the stream of proposed pension drawings seems like a logical idea. However, it may be easier said than done to construct a portfolio that fits the bill here.

"If you structure your holdings heavily towards fixed-income, all the models show that you might as well just have bought an annuity," says Mr Dampier. "While there's a case for having around 10 per cent in fixed-income, a more significant allocation means you're basically just matching liabilities."

In other words, while keeping your drawdown-pension assets heavily in government bonds may give you peace of mind as to their security, the outcome in terms of the income you get could well be worse than an annuity. That's because if you live for many years after retirement, you will miss on the effective subsidy that he would have received from other annuity-buyers who die early on.

So, to make up for the foregone subsidy from not buying an annuity, it is necessary to hold higher-earning, risky assets, which probably means shares. "High income equities and funds would be my choice," says Mr Dampier. "If I could produce a yield of between 3 to 5 per cent and that were sufficient to draw an income from - although my capital will clearly vary over the years - I'd not actually be drawing down on it."

Of course, many people will end up buying an annuity once they hit 75, the age at which the rules require us to do so, or go for an 'alternatively-secured pension' (ASP). The ASP was originally introduced as a sop to a religious group that has moral objections to buying life insurance. But while this course offers a way of passing on remaining funds at death, it incurs huge tax charges.

So, rather than making a straight choice between an unsecured pension and annuitisation, a compromise could produce the optimum result of security combined with some continuing exposure to high-return investments. One way of achieving this is to use the tax-free cash from your Sipp to buy an annuity when you retire, while leaving the remainder tied up in equities.

The coming years are also likely to bring more products that help to bridge the gap between annuitisation and drawdown. For example, the Hartford, an American life insurer, recently unveiled a UK-version of a scheme popular in the US. It offers a guaranteed income for life, combined with ongoing investment in riskier assets. Not only do investors have access to their money, but they also have the chance to pass on some of their pot to their heirs.

KEY POINTS

1. Income drawdown allows you to pass on your pension assets to after your death

2. To do drawdown, you need to have a lot of money outside pensions

3. Your likely longevity also has a huge bearing on whether an unsecured pension is suitable for you

4. At the outset, you have the option to take a tax-free lump sum amounting to 25 per cent of your fund's total value

5. How much you're allowed to take is decided by a calculation based on your age, the value of your assets and the 15-year government bond yield

MORE ABOUT ANNUITIES...

Retirement: Funding long-term care

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