How to run a drawdown plan
In the early years, pension saving is all about growth; time is on your side so you can afford to take a reasonably high level of risk, to ensure you can build as big a fund as possible.
However, as retirement draws closer the focus traditionally shifts from capital appreciation to capital protection – the last thing you want is a nasty stockmarket wobble to wipe a big slice off your savings, just as you're about to retire. So between 10 and five years before your retirement you gradually move your money out of stocks and shares and into lower-risk asset classes, such as fixed interest and cash.
Investing for drawdown
For the 84% of us who are invested in are pension provider's default fund, this process will happen automatically. However, if you don't want to buy an annuity and would rather go down the income drawdown route, this strategy could be wholly inappropriate and see you miss out on the vital capital growth you'll need if you want to maintain a comfortable income throughout your retirement.
Investing for drawdown requires an altogether different strategy, as Patrick Connolly, IFA at Chase De Vere, explains: "If you are planning to buy an annuity it's important you don't suffer a significant fall in your fund, prior to buying the annuity, because you'll have no chance to make up the losses and will be forced to either delay or accept a lower income than you had hoped for.
"In contrast, if you're planning to go into drawdown then there wouldn't be the same need to reduce investment risk before you take the benefits and so you have the opportunity to claw back any short-term losses."
So while annuity buyers should be locking in their gains, income drawdown investors should be holding out for more by keeping a good chunk of their pension in stocks and shares. With the possibility of living for another 30 years you don't want to miss out on the opportunity to keep making money.
Investing for income
However, while you may not be selling out of shares altogether, once you've retired, or start to need an income from your money, you will need to review your investment strategy. Laith Khalaf, head of corporate research at Hargreaves Lansdown, explains: "With drawdown you don't need to de-risk to the same extent but you do need to switch from growth to income.
"This might be from fixed interest, equity income or a combination of the two," he adds. "With equity income you would hope not just for a rising income but also some rise in capital growth."
Exactly which funds you go for will be determined by your attitude to risk.
Fixed interest is usually regarded as lower risk than equities, but Khalaf warns its risk profile is changing. "Fixed interest securities have been driven to historical highs by the low interest rate environment and the search for income. The result is there is more risk in these securities than normally would be the case, and if interest rates start to rise, prices will fall," he explains.
And while yields are broadly in line with equity income funds, capital growth is limited, indeed, when interest rates start to rise, your capital could even fall. "If you are investing in this area we favour strategic bonds that are able to invest flexibly and could therefore offer some protection in the event of a downturn in the fixed-interest markets."
Within equity income you don't necessarily have to limit yourself to UK funds. Khalaf says: "There are lots of global income funds out there that give managers more freedom to harvest an income. If you fancy something a bit racier you could always add some Asian or Far East income funds."
How much income should I take?
In addition to thinking where you invest your money, you also need to think about how much income you should take. Under current rules you can take up to 150% of what you could have achieved with an equivalent annuity, but experts warn that just because you can, it doesn't mean you should: take too much and the risk is you'll run out of money.
Ben Willis, head of research at Whitechurch Securities, says: "How much income is required is purely down to personal circumstances. However, in the current low interest rate environment it's unreasonable to assume that you will be able to generate, say a 10% income a year from your pension portfolio without eroding your capital."
For this reason advisers often recommend limiting yourself to the 'natural yield' of your investments to ensure your capital remains intact.
"Some 3.5 to 4% a year is what you'd be expecting from an equity income portfolio," says Khalaf. So, from a £100,000 fund you can expect an annual income of between £3,500 and £4,000 a year without eating into your capital.
By contrast, if you were to take the maximum you are able to take under the current rules you'd need a yield of around 8% according to Khalaf, which your portfolio may not be able to manage. "8% is far in excess of anything bar the highest risk funds," he explains.
Protecting your capital
While your expenditure might be higher in the earlier years of your retirement, it may not make sense to take too much income or make large capital withdrawals - keep your tax-free cash for any big spends, or take money out of other investments such as Isas. "The big worry is that if you take too much capital, it will reduce your fund's ability to generate an income," warns Khalaf.
"You need to be conservative in terms of how long you are going to live for," he adds. Not only could you live for longer than you might have anticipated but your need for income increase.
"The cost of care is the elephant in the room. This might be the point when you start taking larger slugs of capital."
Mix and match
While limiting yourself to your portfolio's natural yield keeps your capital intact, the downside is that your income is not fixed – it will move up and down according to the yield your portfolio generates. This could be unsettling for some investors but Khalaf stresses that you don't need to put all your money into drawdown. "It doesn't have to be a case of annuity or drawdown. You can get some fixed income from an annuity plus some variable from drawdown."
Likewise, if you feel that income drawdown isn't working for you and you would prefer the certainty of a fixed income you can annuitise at any point.
Alternatively, you can plan simply to use income drawdown as a temporary way of generating an income – giving your capital more time to grow – and only purchasing an annuity when you are older, and quite possibly less healthy. By adopting this approach you should get a higher income than you would have done if you had bought an annuity when you first retired.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.
This is more usually a feature of car insurance but it can also crop up in contents, mobile phone and pet insurance policies. An excess is the amount of money you have to pay before the insurance company starts paying out. The excess makes up the first part of a claim, so if your excess is £100 and your claim is for £500, you would pay the first £100 and the insurer the remaining £400. Many online insures let you set your own excess, but the lower the excess, the more expensive the premium will be.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.
An alternative to an annuity, income drawdown (also known as an unsecured pension) allows you to take income from your pension fund while the fund remains invested and so continues to benefit from any fund growth. The drawdown of income has to be calculated carefully as taking too much income could exhaust the pension fund so experts say the annual drawdown must not exceed what the assets would normally yield in an average year. The invested pension fund could also be hit by market turbulence and the value of the assets could fall.