Annuity alternatives: Introducing Income Drawdown

March 18, 2015

For many people, pensions are a bit of a mystery. In actual fact, the concept of a pension is really straightforward. During your career, you put away some money each month. That money sits in a pot that you can’t touch until you reach retirement age, at which point you can use it to pay your monthly bills. Hopefully, there’s enough in there to do that until you die.

See? Not that complicated. So, if it’s not the concept of a pension that is complicated, what is it? Well, it’s everything around the pension – the tax relief, rules and limits as you add to the pension, and the different ways you can access your pension when you decide to retire.

We’ve already covered annuities. Now it’s time to take a simple look at the main alternative, Income Drawdown.

What is Income Drawdown?

It already sounds unnecessarily complicated doesn’t it? It isn’t, really.

Let’s say that you’ve got a £100,000 pension pot, which is invested in a variety of funds, earning around 5% each year.

Now, remember – with an annuity, you take that pot and buy a product which guarantees you a certain amount of money each month. You give the pot to an insurance company, they take a cut, and you get paid every month until you die.

With Income Drawdown, the money is invested, benefitting from any growth. Each year, you take a little out to cover your bills and, depending on the amount you take from the pot and the investment growth, your fund will either grow or be gradually consumed bit-by-bit.

At 5%, your £100,000 pot would earn £5,000 in the first year. If you need £7,000 a year to pay your bills then, assuming you took the income at the end of the year, you’d be left with a pot of £98,000. £5,000 came from the earnings (in interest) of the pot, and £2,000 came from the pot itself. In effect, you’re ‘drawing down’ some of your pension pot each year.  If you take the income on a monthly basis then the calculation is slightly more complex, but you get the general drift.

Advantages of Income Drawdown

Income Drawdown schemes afford you much more flexibility than with an annuity. Up until April 2015, there were restrictions on many plans around how much other guaranteed income you must have, as well as how much you could take out of your pot at any given time, but these rules are set to change. From April, you can take cash out of your retirement pot as and when you want to.

This development led to the now famous ‘you can buy a Lamborghini if you want’ comment from a politician. Well, yes you could. But, the reality is that if you’re the type of person who has worked hard to save up enough money to cover 30 years or more of retirement, you’re unlikely to be the type of person who would head to Mayfair and blow it all on a supercar which will cost you tens of thousands to run each year, and which you’ll be scared to park in Asda in case someone dinks it with a trolley.

Added to that the fact that the money you take from the pot that falls outside of the 25% tax free amount is added to your income for that tax year and taxed accordingly.  So, if you decide to go for the Lambo and withdraw £100,000 in income you’ll find a large proportion of that will be subject to 40% tax thus significantly reducing the amount you actually receive. Not sensible.

If you skipped the Lambo and left the money in your pot, and moved your pension pot into drawdown in stages then each time you move an amount into drawdown, you get 25% of that amount tax free, with the rest taxed like income if you withdraw it. Or you can access the full tax free lump sum when you place all your funds in drawdown and defer the taking of income to a more appropriate time.

Also, because your money is still invested, your pension could continue to grow. That’s not guaranteed, of course, but if your investment decisions are right, your pot could, in theory, increase at a faster rate than you need to take out. Getting richer in retirement sounds good to us.

Finally, as you’re not handing your pot over to an insurance company, whatever is left in it when you die can be passed on to your loved ones.

Disadvantages of Income Drawdown

There’s one big one that you need to consider. What if you start to draw from your invested pot at exactly the same time there is a huge stock market crash? That’s what happened to people in 2008, and there’s no reason why it won’t happen again in the future. The stock market has gradually gone up over time, but that steady rise has been punctuated with huge peaks and troughs. If you retire and hit one of those troughs, your pot may never recover, and you may need to go back to part-time work to make up the shortfall.

With all the extra freedom and flexibility comes increased responsibility, so you’ve got to be confident in your investment strategy, will probably need to take advice on (or will need to soundly research) the tax implications of withdrawing money, and you’ll need to ensure that the money doesn’t run out too soon.

Is Income Drawdown for you?

Income Drawdown definitely carries with it more risk than an annuity, but it also has the chance for greater reward. In essence, you’re sacrificing the security of an annuity for flexibility and potential.

If you consider yourself to be a little more knowledgeable about all of this than your average Joe, and are used to investing in funds via your Stocks and Shares ISA, or perhaps you’re even managing your pension yourself in your Self Invested Pension Plan (SIPP), then an Income Drawdown approach could be for you.

 

This article is for general use only and is not intended to address your particular requirements. It should not be relied upon in its entirety and shall not be deemed to be or constitute advice. The value of investments can fall as well as rise. You may not get back what you invest.

GreenSky Wealth Limited is authorised and regulated by the Financial Conduct Authority. FCA No. 629624. Registered Office as above. Registered in England and Wales, Company No. 07103441.The Financial Conduct Authority does not regulate Tax Advice.