As income drawdown becomes an increasingly popular retirement choice Steve Hunt takes us through the pros and cons
Income drawdown, or unsecured pension as it is now called, is not for everybody but is becoming much more popular as an alternative to buying an annuity.
The reasons for the increased popularity in income drawdown are a combination of the worst annuity rates for 50 years and more flexibility on income and death in drawdown. That said, income drawdown still needs to be given care and consideration and, if poor investment decisions are made, has the potential to significantly reduce an individual's retirement income.
In simple terms, the amount of income that is provided in retirement is determined by the underlying investment.
With a conventional guaranteed annuity, the underlying investment is primarily government stock and A+ rated corporate bonds and currently offers an overall investment return of circa 4% to 5%. If you then take out charges this reduces the return to the annuity holder to around 2% to 3%.
Annuities are, of course, insured benefits and as such if the annuity holder lives longer than expected their returns will be greater than 2% to 3% as they have taken more money out of the 'pot' than was anticipated. Conversely, if the annuity holder dies sooner, their individual return will be less.
Based on the highest single life annuity rates available at the time of writing, this is how actual returns on annuities look, see table one:
In the example above, even if our male retiree lives to be 100 years old, based on the highest single life annuity available today the actual return on fund equates to 6.3%. Even based on a life expectancy far in excess of the average (100 years of age) and on a single life basis the highest possible return is still less than you can currently get from a high street building society (Chelsea, at the time of writing, are offering 6.9% fixed for 12 months). Having made that point, however, what you cannot get from the high street is an interest rate guaranteed for 35 years and in economics anything can happen; look at interest rates in Japan or indeed what happened during the great recession of the 1920/30s where there were negative interest rates!
As an alternative to using your pension 'pot' to buy an annuity with an insurance company, you can choose to keep your pension fund invested and, subject to some restrictions, draw an income direct from the fund. Any income you take is taxed the same as an annuity as earned income-PAYE.
How income drawdown works
Every month the Government Actuaries Department (GAD) publishes a 'rate' for use in determining how much income can be drawn from an individual's unsecured pension fund (the fund that has been earmarked for income drawdown). The rate is determined by FTSE UK ilts Indices, namely the yield indices for 15 years as published by the FT on the 15th of every month. This gilt rate is then rounded down the next 0.25% and applied to a GAD table produced by Her Majesty's Revenue & Customs which can be found at http://www.hmrc.gov.uk/pensionschemes/drawdown-tables.xls.
From 6 April 2006, the maximum that can be 'drawn' from someone in unsecured pension (under age 75) is 120% of the pension calculated by the above tables, with no minimum amount. It is this lack of a minimum which has also boosted the popularity of income drawdown in that it is now possible to earmark your retirement fund to provide unsecured income, take your 25% pension commencement lump sum (tax free cash) and defer receiving any income.
In other words, Mr X with a fund of £60,000.00 who is aged 55 can put the whole fund into drawdown, take tax free cash of £15,000 and leave the remainder invested and draw an income of zero. The option of zero income however disappears at age 75 when unsecured income or income drawdown becomes alternatively secured pension (ASP). In light of poor value annuities this is perhaps not such a bad thing though and ASP does have its place, but that's a whole article in itself.
So what are the disadvantages of income drawdown?
Quite simply, high charges and risky investment strategies. Most drawdown arrangements are expensive in terms of % of fund to run. For example; an insured drawdown policy for a male aged 60 with £100k would incur total charges of 1.8% with Prudential and 1.4% with L&G. Therefore, if you are looking for a totally risk free investment such as a deposit account type fund paying 6% then your actual return is going to be 4.6% at best. If you want more than 4.6% then you will have to take risk with your investment. Remembering that between Jan 2000 and March 2003 the FTSE 100 fell by over 50% so those going into an equity based drawdown fund in January 2000 probably did not make a wise decision.
This itself brings more problems. The FTSE is extremely volatile and likely to remain so - so not really conducive to a stress free retirement!
The caveats for IFAs is the ongoing management of funds. When dealing with clients who have effectively retired and therefore do not have the earning potential to make good any losses, this is a labour intensive job and with typically 0.5% trail, not particularly profitable for the IFA.
There are alternatives to the insured drawdown route which can work very well. There are a number of SIPP/drawdown wrappers available at relatively low costs and, a growing number of 'group' SIPP/drawdown facilities coming to the fore which can have cafeteria type charging structures and can be quite reasonably priced. As an example we, at Rockingham plc, operate a 'group' type SIPP/drawdown facility though one such wrapper that charges a flat fee of £30 per month+VAT.
Structured products may be an alternative for some and are becoming more popular again. We do use one structured product which is well suited to drawdown which gives a 10.25% return over a fixed 10 year term which is low risk and has 100% fund guarantee on death. We find this works very well with the low fee group drawdown facility we have.
On the investment side the challenge is simply finding the right portfolio mix that will give a reasonable return of more than can be gained from an annuity with a low risk profile.
So what are the advantages of drawdown?
The two main benefits of drawdown are flexibility and death benefits (under age 75). When someone goes into drawdown they can, at any time (investment permitting) buy an annuity on the open market with any provider. As there is the possibility of interest rates dropping to zero there is also the possibility of them rising. In November 1979 the UK bank base rate was 17%. You also need to consider that, according to the government actuary a male retiring at 50 will live for another 30 years which is a very long time to go into a totally irrevocable annuity contract paying a 3% return. People's personal circumstances can change dramatically in five years let alone 30.
The other main benefits are those on death. On death during income drawdown the resulting fund can be used to continue in drawdown for a dependant, buy an annuity for a dependant, or be paid out in cash less a tax charge of 35%.
Here is a comparison for our male retiree, retiring at age 65 with his £50k fund, who dies at age 75:
(a) Takes a single life annuity paying £3,666.00 p.a. so will receive, in total £36,660.00 and nothing else will be payable to any of his family or estate.
(b) Goes into income drawdown using a low cost drawdown and a structured product investment paying 10.25%. £3,360.00 is maximum income so he will have received £33,600 in income but his fund would have grown to just over £66,000. So an additional £42,900 (£66,000 less 35% tax) is payable to his widow or children or estate etc. Or the whole £66,000 could be used to buy a single life annuity or continued income drawdown for his widow.
Effectively, drawdown can give you the equivalent of a single life income but the equivalent of 100% spouses (or more) joint life benefits.
A simple guide is not to think of a pension fund as anything other than what it is, a sum of money. If our male retiree went to his IFA at age 65 with £100,000 of his own money wanting a retirement income would the IFA recommend a purchase life annuity? In the last three years we have received over 10,000 enquiries for annuities and have sold two PLAs, one of which was an impaired life PLA with a 17% annuity rate.
Decisions being made by clients going into retirement, based largely on advice given by IFAs are likely to affect a third of a client's entire life, and based on a sum of money that:
(a) It has taken their entire working life to accumulate and
(b) Is possibly going to be the largest sum of money they will ever have.
Not a responsibility an adviser should take lightly, especially when the product they are recommending is totally irrevocable.
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