Ed Bowsher looks at income drawdown and explains how you could make this work out for you.
Income drawdown has actually been around for a while, but the chancellor made it a more attractive option for many people in the Budget. More folk can now withdraw larger sums from their pension pots via income drawdown.
With income drawdown, your pension pot stays invested and you just take money out of your pot every month or year.
There are two types of income drawdown – Capped drawdown and Flexible drawdown:
Flexible drawdown gives you the freedom to take as much money from your pot as you like. Whatever you leave in the pot stays invested.
The only catch is that you must have a secure pension income of at least £12,000 a year to qualify.
This secure income could include:
- your state pension
- income from another company pension – this would probably be a final salary pension
- income from a pension annuity that you’ve bought already
For the annuity, you could use a separate pension pot that went with a previous job. But if you’ve only got one pot, you could divide it and use some of the pot to buy an annuity.
Income from savings accounts or other investments doesn’t count towards the secure pension income.
Look at this example:
- Bob is 66. He’s about to retire.
- He’s receiving the full state pension which works out at £5880 a year. He’s not eligible for any other benefits.
- He has a pension pot worth £200,000. He has no other pensions.
- He has £40,000 invested in stocks and shares (outside his pension) which give him an annual income of £1600.
- He also has £20,000 in cash Isas that pay interest of £400 a year.
- He owns his home and has paid off the mortgage.
If Bob wants to go into flexible drawdown, he needs to buy an annuity. He can’t use the income from his shares or the cash Isa to go towards his secure pension income.
The good news is he can split his pension pot to fund an annuity purchase. So some of his pot can go towards an annuity while the rest will go into flexible drawdown.
So Bob could take £105,000 from the pension pot to buy an annuity paying £6500 a year.
Add the annuity (£6,500) and the state pension (£5,880) together, and Bob has a secure pension income over the £12,000 mark.
Bob now has £95,000 left which he can put into flexible drawdown if he wishes.
If you have a secure pension income worth less than £12,000 a year, you can still go into capped drawdown.
With capped drawdown, you need to figure out how much money you would get from an annuity if you bought one now. Your withdrawal limit is roughly 150% of your maximum possible annuity payment.
You can find your withdrawal limit using the ‘GAD’ tables (Government Actuary Department.) If you’re younger than 75, your personal withdrawal limit will be revised every three years. If you’re 75 or over, your limit will be revised once a year.
A wide range of investment and pension companies can put your pot into income drawdown. You’ll have to pay a fee to your drawdown provider. You don’t have to use the company that provided your pension.
Income drawdown has been around for a while, but the old rules were more restrictive. For example, if you were in capped drawdown, you were only allowed to withdraw 120% of your maximum annuity payment.
And you could only go into flexible drawdown if your secure income was £20,000 a year or more.
Now, let’s look at whether income drawdown is a good idea for most people.
Could income drawdown work for you?
Income drawdown has four big plus points.
1. It allows you to generate a bigger income than you’d get from an annuity
As you probably know, annuities have given rotten returns in recent years. You can easily get a better return with income drawdown.
As we said above, you can take as much money as you like from your pot with flexible drawdown.
And even if you’re only eligible for capped drawdown, you can still take an income equivalent to 150% of your annuity.
2. Your remaining pension pot can stay invested, perhaps in the stock market
If you buy an annuity, your annuity provider will use your money to buy gilts (UK government bonds).
The providers buy these gilts because they give a fixed, predictable return for the long-term. Gilts are the classic, low-risk investment.
However, the problem with gilts is that they’re unusually expensive at the moment. So if you buy them now, you probably won’t get a great long-term return. (Gilts are expensive because interest rates are low.)
If you keep your money in income drawdown, you can control where your money is invested. Then you can put at least some of your pot into the stock market where you could get a better return.
To be clear, we’re not suggesting that everyone should put their whole pot into the stock market. That would be too risky for many retirees, but a mixture of shares, bonds and cash could work well. If you are unsure you should seek advice before investing.
3. It allows you to keep money in the pension pot. That means you can keep some tax protection
From April 2015, you’ll almost certainly be able to take all your money out from your pot. So you might think that makes more sense than going into drawdown.
However, if you go into drawdown, you can keep some money in your pot and that will reduce your tax bill. You won’t have to pay any capital gains tax, and your income tax bill may be reduced as well.
If you take money out of your pot, your cash is then subject to the ordinary tax rules. You might end up paying income tax at 40% or 45% on at least some of your withdrawals.
4. It’s more flexible than an annuity
If you buy a conventional annuity, you’re locked into that annuity for the rest of your life.
If you realise later on that you made the wrong decision, you can’t go back. You’re stuck.
It’s a different story with income drawdown. You can go into drawdown and then change your mind. At that point you could switch into an annuity or just withdraw all the money. If you go into drawdown, you still have pension freedom.
If you’re in capped drawdown, you can carry on paying into your pension pot even when you’re drawing money out.
This doesn’t apply if you’re in flexible drawdown.
But income drawdown has some minus points too.
1. Charges can be high
The charges for income drawdown can be high. So if your pot is small, say lower than £50,000, it may not be the most sensible move.
You should also get some professional advice before you go into drawdown and that will cost money too.
2. You might run out of money
People often underestimate their life expectancy. There’s a fair chance you could live until you’re 90 – or even 100!
If you do live that long, you may run out of money before you die. If you buy an annuity, you have a guaranteed income for life. There’s no such guarantee with income drawdown.
You could even run out of money at 75 or younger. The more money you withdraw each year, the greater the risk you’ll run out of cash . There’s also the risk that you’ll make poor investment decisions. If, for example, you invest your whole pot in risky biotech shares, you could easily end up with a much smaller pot and a lower retirement income as a result.
Annuities, of course, give you an income for life. That lifelong guarantee means they can be the right option for some people.