Income drawdown is an alternative to annuities for those between 50 and 75. In the same way as a conventional annuity, any tax free cash entitlement must be taken at outset, as it cannot be deferred until a later date.
However, unlike a conventional annuity you are not buying a guaranteed income for life. Instead you can choose an income between 0% and 120% of the equivalent single person’s annuity. In other words if you were able to buy a single life annuity of £10,000 you can choose an income of between £0 and £12,000 per annum.
The monies in your pension fund remain invested and therefore whether income drawdown proves to be a success will largely depend on how these investments perform.
If investment returns are good you are likely to be able to take an increasing income as the pension fund increases in value, but alternatively if investment returns are poor your income will decrease.
As such income drawdown is only likely to be suitable for those who are prepared to take a more optimistic view of potential investment returns.
What Are The Advantages Of Income Drawdown?
- Ability to vary income – income between 0% and 120% of the single life annuity can be drawn and can be varied by the pension holder. Therefore income drawdown can be attractive to those who are unsure what their future income needs will be.
- Possibility of higher income – the maximum income available under income drawdown is based on the equivalent single life annuity. Many people would need to build in surviving spouse’s benefits etc to a conventional annuity that would reduce the level of pension available. Under income drawdown this is not a problem because should the pension holder die, there are benefits that are not available with conventional annuities (see death benefits below).
- Death benefits – with conventional annuities the fund dies with the policyholder (subject to other benefits that can be bought within these plans such as dependent’s pension and guaranteed periods). Under income drawdown there are three options available after death. Firstly the remaining fund can be paid as a lump sum (subject to a 35% tax charge). Secondly the surviving spouse can continue to use income drawdown. Finally the surviving spouse can convert the remaining fund and buy an annuity. As such income drawdown provides significant benefits that are not available under conventional annuities.
- Potential for a rising income – if investment returns are kind and the fund increases by more than the amount being withdrawn and other fund charges, then there is the possibility that the maximum income permitted will increase through time to take into account the higher fund value and the typically higher annuity rates that are available as one gets older.
- Ability to defer buying an annuity if annuity rates are low – buying an annuity locks one into the annuity rates that are available on the date of purchase. Using income drawdown can defer this decision, and can be particularly beneficial if you believe that annuity rates will rise in the future.
- Annuity rates rise the older one is – annuity rates tend to rise based on age. The logic behind this is that the annuity will be paid for less time if the person purchasing the annuity is 75 rather than 65. This is not quite as straightforward as it would seem because of a factor known as “mortality drag”. At birth life expectancy may be say 75 years. However that does not mean that on our 74th birthday we need to put as much as possible into our last 365 days. This is because the figures are an average, and therefore those reaching 74 can be expected to live significantly past age 75 as many people will already have died prior to that age, therefore creating the average for those who live well past it. In other words, whilst annuity rates will usually increase as one gets older, the increase is not proportionate.
Disadvantages Of Income Drawdown
- Investment risk – if the investments chosen under perform, then the amount of continuing income under income drawdown and ultimately when an annuity is purchased will fall.
- Annuity rates could fall – thereby meaning that future income taken from income drawdown and ultimately from a conventional annuity will fall, even if the underlying investments have performed well.
- Charges – under income drawdown your monies remain invested and therefore incur ongoing fund charges that would not apply under a conventional annuity.
Income drawdown can be a valuable retirement planning tool for the right person. Typically it suits those who are not adverse to investment risk, and who have larger pension funds to be able to absorb the ongoing fund charges.
It is even possible to combine income drawdown with annuities by using part of a pension fund for each purpose.
It can also be a useful tax planning tool in terms of protecting the value of one’s estate for surviving spouse and the next generation.
It is important that the correct investment strategy is utilised in accordance with one’s risk profile and income levels. Ideally short term income needs should be set aside in income producing assets such as cash, gilts and corporate bonds, with the longer term monies in assets such as equities that have the potential to yield higher returns over the medium to long term.
It is highly recommended that expert advice be taken, and a financial adviser would be delighted to assist in producing the right balance for you.