Don't let income drawdown eat up your pension

Falling gilt yields and a run of poor investment performance have turned the flexible retirement income options available under an unsecured pension (USP) into something more akin to a financial straitjacket.

"We're seeing people in USPs getting a bit of a shock when they come to their five-yearly review and have their income limits recalculated," says Bob Perkins, technical manager at financial advisers Origen.

"It's not so noticeable if they haven't been taking a lot of income, but those taking the full 120% could see their income levels fall dramatically."
Although the five-yearly review helps avert an income problem, it is still possible to exhaust a fund. "There isn't a pension pot size at which you're compelled to quit a USP and take an annuity. If you take the maximum level and your fund's performance is poor, your fund can disappear quickly," adds Perkins.

For example, if a 60-year-old man went into a USP in July 2006, when the Government's Actuary Department (GAD) rate was 4.50%, his £100,000 fund would have enabled him to take a maximum of £7,680 a year.

Assuming the GAD rate remains at the August 2010 level of 3.75% and he achieves a return of 2% a year on his investments, making his fund worth £69,641 by the time of his review in July 2011, his new maximum income level would be £5,596.

While the amount you can take from your self-invested personal pension may have fallen, it still remains a valid means of accessing retirement income. "Annuities remain unattractive to many people," says Billy Mackay, marketing director at SIPP provider AJ Bell.

"People just don't like the idea that when they die their fund dies with them. At least in a USP you have greater control and if you die before 75 any remaining fund, minus 35% tax, can be passed to your beneficiary."
The government's consultation on retirement options has muddied the water. "As it is looking at removing compulsory annuitisation at age 75, you might want to delay buying an annuity until more detail emerges," says Lee Smythe, managing director of Killik Chartered Financial Planners.

If you do opt for a USP, the simplest way to address the issue of a rapidly eroding fund is to take less than the maximum level of income. However, where this isn't possible, a number of strategies can give you greater flexibility and, in some cases, income security.

Annuity option

Smythe says he has seen a growing number of people use some of their pot to secure an income through an annuity.

"Buying an annuity can underpin your income, allowing you to be more relaxed about investment returns from the rest of your pension pot. It's particularly popular where someone has a pension with a guaranteed annuity rate, as these are generally too generous to give up."

Instead of plumping for a lifetime annuity, it's also possible to take a fixed-term annuity such as those offered by Living Time and LV=. These guarantee your income up to a maximum of 120% of the GAD rates for a set period, which could be anything from three years to age 75.

At the end of this period, you get a guaranteed return that you can use to buy another fixed-term annuity, purchase a lifetime annuity or stay in your USP.

"We see a lot of people using these as part of their pension fund, as it gives them security over what they'll receive and what they'll have at the end of the period," says Steve Lowe, marketing director of Living Time. 

As an example of how a fixed-term annuity might work, imagine that a 62-year-old requires annual income of £78,000. He takes out an eight-year fixed-term annuity with Living Time that pays him this amount. To achieve this level of income, he needs to put £1,000,000 of his £2.2 million SIPP into the plan.

At the end of the eight years, he's received £624,000 in income and gets a guaranteed maturity value of £597,356 back into his pension.

Lowe adds: "As well as providing an income, the other major benefit is that a lot can change in five years. If your health deteriorates or your partner dies and you no longer need a spouse's pension, this could boost your annuity."

For example, a 60-year-old with a 55-year-old wife and a £100,000 pension pot could take out an annuity with a five-year guarantee and a 50% spouse's pension paying £5,479. If instead he took out a fixed-term annuity, he could secure a similar level of income (£5,486) until age 75.

If his wife dies in this time, he wouldn't need the spouse's pension and could buy an annuity paying £6,503 with the pot he receives back.
If you'd prefer more investment risk but would like some protection from market volatility, there is a third option. A variable annuity product, such as those offered by Aegon, Sun Life Financial of Canada and Metlife, is worth considering.

Peter Carter, head of product marketing at MetLife, explains: "These allow you to guarantee your income and, as your fund remains invested, there's potential to increase your income, as you can lock in investment growth."

This means that, even if the stock market falls, you won't see your income fall. Naturally, being able to lock in growth doesn't come free.

"The trouble with third-way products is that the guarantees eat into your fund and you can also find you have to start with a lower level of income than if you had a USP," says Perkins.

For example, from MetLife you can get between 3.75% and 4.75% of the fund each year, depending on your age. This compares with between 5.30% and 9.10% from the maximum GAD rates, although the higher level does risk fund erosion. 

Scheme pension option

Another option is a scheme pension offered by more specialist SIPP providers, including Rowanmoor, Hornbuckle Mitchell and Dentons, and only one mainstream insurer, AXA.

This allows you to sidestep the GAD rates and have an income set by actuaries according to your age, health and investment profile.

"It's very much like an individual annuity, but with the benefit of leaving your pension invested," says Mike Morrison, head of pensions development at AXA Winterthur.

But, unlike an annuity, there's no guarantee on the amount you'll receive. Most providers will insist on a three-yearly review, when your income could change, depending on investment performance and your health.

Neil Merryweather, director of consultancy at Rowanmoor Pensions, says this has become a valuable substitute for an alternatively secured pension at age 75, paying 10.30% compared with a maximum of 8.55% on an ASP. "It's possible that a scheme pension might not be relevant in this way following the government's review.

But it will probably still be useful if you're in poor health," he explains. "We had a client who was able to take an annual income of 35% of his fund when he produced a doctor's letter saying he only had two years to live."
Death benefits also need to be considered. As well as taking out a guarantee to return 10 years of payments, it's possible to have a fund surplus paid as a spouse's pension or to a beneficiary, in which case it will be taxed as their income.

"After age 75 the rules are different. There is a potential tax charge of around 73% on any fund surplus. But this still gives a benefit over the ASP rules, which could see tax of 82% being levied," says Morrison.

It's worth reviewing your position regularly. The rules stipulate a five-yearly review, but advisers are keen to look at your position more frequently. "We encourage annual reviews," says Perkins.

"This allows you to adjust your investment strategy or the amount of income you take, so that you don't get a shock further down the line."

Work out your unsecured pension income

Understanding the calculations behind your pension income can help you decide on your investment strategy and your approach to taking income.

The amount you'll receive from your pension is calculated with reference to the Government Actuary's Department rate. This is the gross redemption yield on the FTSE 15-year gilt. The takes the GAD rate published in the Financial Times on the 15th day of the previous month.

This is rounded down to the nearest quarter of 1%, which can then be used with the GAD tables to obtain the basis income that can be paid per £1,000 of USP.

As an example, using the GAD rate for August 2010, 3.75%, the basis amount for a 65-year-old man is £67 per £1,000 of fund.

If he had a fund of £100,000, this would give him £6,700 a year, which is roughly what he would receive if he took a standard annuity. But, as the USP limits are 0 to 120% of the GAD rate, he would be able to take up to £8,040 a year from his pension.

This article was originally published in Money Observer - Moneywise's sister publication - in September 2010

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