Adrian Walker discusses the advice challenges and opportunities surrounding changes in capped drawdown limits
There has been much commentary over recent times as to the effect the government‘s policy on Quantitative Easing has had on the levels of retirement income available to consumers from their hard-earned pension savings.
This has not only had an impact on the levels of lifetime annuity income that it has been possible to buy, but also on the annual levels of income available through the use of capped income withdrawal arrangements.
Hardest hit of all have been clients who have been using income withdrawal for a number of years and whose maximum available annual income under a statutory review was re-calculated since April 2011.
These clients were also hit by changes in government policy as the formula used to determine the maximum income that clients could access in any one scheme income year was changed.
The picture in the shorter term is changing now on both fronts. First, the government announced earlier this year that clients whose income withdrawal savings were currently subject to a three-year statutory review period would see an automatic uplift of 20% on the maximum annual income available to them from the start of their next scheme income year.
This increase would, in effect, be based on their age, the capital value of their drawdown fund and the gilt yield that applied at the earlier statutory review date, not on the current position of all three aspects.
Increase in capital values
At the time of writing this article, the gilt yields that determine the maximum annual income for capped drawdown arrangements were, 12 months ago, at the lowest level ever. In recent times, gilt yields have been increasing quite significantly.
This, combined with the relatively strong performance of most of the major stock markets over that period, may well have seen increases in capital values of these funds, or at least the ability to maintain capital value while taking required income from those savings.
For individuals currently in this situation there is the potential, if their pension provider offers the required facilities, to look forward to increases in annual income that are well above the guaranteed 20% uplift they are already expecting. The following examples illustrate the potential additional increase in the maximum available income that some clients could enjoy.
Bob was aged 60 in October 2012 when his drawdown fund was worth £200,000. His fund had a statutory review at that time when the gilt yield was 2% and the maximum available annual income was calculated as being £9,600 a year.
When Bob’s new scheme income year begins in October 2013, the maximum annual income will automatically be increased to £11,520, regardless of the current capital value of his drawdown savings and current gilt yields as a result of the government announcement earlier this year.
Fortunately, Bob’s drawdown provider offers the facility for an annual rebasis review to be provided for Bob to consider. Bob has managed to maintain the capital value of his drawdown fund over the past 12 months, after taking the income withdrawals he requires.
As Bob is a year older and the current gilt yield is 3.25%, the maximum annual income available to Bob from the annual review has increased to £13,200 - an overall increase of 37.5% on his current entitlement. If Bob accepts this new threshold, the new limit will be locked in for a new three-year statutory period, regardless of how the capital value of his drawdown savings moves in that period.
Had Bob been a female, the effective increase offered by use of the annual rebasis review would have been even greater. This is due to the fact that the income factors now are based on gender neutral rules using factors for male lives, whereas the previous review would have been based on lower female rates.
The equivalent figures would have been a previous maximum income of £9,000, automatically increasing to £10,800 from the start of the new income year, but with the annual rebasis review providing potential annual income of £13,200, an increase of 46.66%.
Many older contracts do not provide an annual rebasis review facility and even where this is available it often has to be requested. This makes it more difficult for advisers to be aware of when movement in gilt yields combined with the current capital value of a client’s drawdown savings could produce a beneficial outcome to the level of annual income that is available.
Is access to such an option something that an adviser should point out to clients that could be of value in the future as part of their ongoing future income planning?
Opportunities and challenges
In this article, I’ve highlighted the opportunities that exist for clients to be able to increase the potential annual income available to them from their capped drawdown arrangements when their next annual review falls due.
However, this should not be seen simply as a good news item that generates a rush for clients to sign up to taking any higher maximum annual income that may be created as part of an automatic long-term retirement income strategy.
For some clients who have significant other assets that will also be included as part of that strategy, they may have a plan to liquidate their pension savings to deliver maximum income on the basis that other investments will be kept untouched for later use.
The significant reductions in the maximum income available from income withdrawal contracts that many clients suffered over the past two years were not only a result of government policy changes. They were also due to the fact that the levels of income being taken were much greater than the underlying investment portfolios could deliver by way of capital growth over the period.
In looking at Bob’s example, the maximum income that could be available as a result of the annual review assumes income extraction of 6.48% a year.
If the annual TER of an average investment portfolio required to deliver this is assumed to be 1.5%, to which must also be added the adviser charges agreed with a client, it is likely that annual returns of between 8.5% and 9% would be needed to avoid significant capital erosion.
The ultimate effect of this would be to reduce the sustainability of income from these savings for the longer term.
Realistic levels of income that could be taken need to be discussed with clients based on their attitude to risk, the investment portfolio then selected, and how those pension savings fit into the client’s wider retirement income planning.
The benefit of having a higher maximum income threshold available is two-fold. It provides clients with the ability to deliver a solution for meeting unexpected or short term increases in income needs from their pension savings or to use as a means of delivering effective estate planning in their lifetime through gifting of income under the normal expenditure rules.
However, to be able to deliver the appropriate solution is a no-cost win for both adviser and client alike.
Adrian Walker is retirement planning manager at Skandia
Interest rate outlook unchaged
FCA made demands last week
'Unsung' part of FSCS work