Is income drawdown for you?
Instead of handing over your pension over to an insurance company in return for a fixed income for life, income drawdown allows you to leave your pot invested and cream an income off the top.
April 2015 changes
Following the pension reforms all investors are able to draw down as much or as little as they like. You can leave it all invested if you don't need the income, you can take off a monthly sum to live off, or save it for ad hoc lump sum withdrawals as and when you have big expenses to pay for.
Jonathan Lay-Watts, director of Wealth At Work says this flexibility allows investors to alter their income as and when their needs and spending changes – something you cannot do with an annuity. "Generally people have a ‘u shape' income requirement in retirement," he explains. "Initially they spend a lot, then it slows then in old age they need more care."
He adds: "People are so used to thinking an annuity is the only option, but they give no consideration to life stages. The product was designed at a time when life expectancy in retirement was just five or six years – the product hasn't changed but people's lives have."
The benefits of drawdown
The income drawdown route is expected to become increasingly popular following the announcements made in the April 2014 Budget and arrangements are already being provided at a low cost through online Sipp providers, which have sprung up to challenge the expensive offerings from more traditional pension providers.
The death benefits of income drawdown may also give it the edge over annuities.
In order, for annuities to provide a guaranteed income they need the money left over by those policyholders that died early into their contract to subsidise payments for those that live longer than the insurance company anticipated. This means that if you have a bog-standard annuity without any guarantees, any money that hasn't been paid out to you in payments goes straight back to the provider. So if you die early into your contract your family won't get any of your hard-earned cash.
Providers recognise that this isn't popular and so there is an option to select a payment guarantee of between five and 10 years - so if you died five years into a plan with a 10-year guarantee, payments would continue to be made to your family for a further five years. No remaining capital, however, would be returned.
By comparison, investors in income drawdown have more scope to leave any unused retirement savings for their partner or family. Beneficiaries can either maintain the plan, leaving the money invested and taking an income or they can convert it to an annuity. They can also take the money as a lump sum. This money is paid tax free is death occurs before age 75. After that point it is taxed as income.
So income drawdown offers you control over your money and flexibility as to how to take it. If you die it provides the peace of mind that your money can be passed on to your family.
But however appealing income drawdown might seem, it's not for everyone. For starters it means you need to keep your money invested – choosing appropriate funds and keeping a tight watch on them to check performance doesn't go awry.
This is easily done if you can or are willing to pay for financial advice, but if you can't or won't you are going to have to commit time to both choosing and reviewing your portfolio, and if you don't fancy doing this when you are 60 or 65, there's a good chance you won't fancy doing it when you are 80 or 85 either.
Given the risks involved you also need to have a reasonable sized pension fund: you need to be able to absorb some losses here and there and have enough to generate a sufficient income without taking too high a risk with your capital.
How much money do I need?
Laith Khalaf, head of corporate research at Hargreaves Lansdown, says: "If this is going to be your only source of income you would want to have a fund worth at least £150,000, but if you had other sources of income you could do it with less."
So just because the restraints on how you generate an income retirement have been lifted, it doesn't necessarily follow that you should ditch the traditional route of an annuity that pays a guaranteed income for life.
However, if you have a larger pension fund, a higher tolerance for risk and feel that you need the flexibility to change the level of income you take from your fund, income drawdown might just be a better solution.
If you have both the confidence and the competence to select and monitor your investments it's cheap and easy to run your income drawdown plan from one of the many online Sipps.
Do you need advice?
However, given the amount of money at stake and the importance of making sure your money lasts as long as you do, it can make sense to shell out for some independent financial advice. In addition to helping you manage your pension, an adviser will also be able to help you through other financial challenges you might face in retirement such as paying for care as well as estate planning, which ensures that your money goes where you want it to when you die.
And, of course, you don't have to just go with income drawdown - in the new world it will be all the more easy to mix and match your options. Starting off in income drawdown before buying an annuity once you get older - and less healthy - or securing some fixed income with an annuity but giving a portion of your money some scope to grow in income drawdown. Striking this balance correctly might be difficult to do yourself - but it is an area where the advice of a good IFA can be worth its weight in gold.
Like a self-select ISA but for pensions, self-invested personal pension is a registered pension plan that gives you a flexible and tax-efficient method of preparing for your retirement. It gives you all sorts of options on how you put money in, how you invest it and how it’s paid out and offers a greater number of investment opportunities than if the fund was managed by a pension company. SIPPs are very flexible and allow investments such as quoted and unquoted shares, investment funds, cash deposits, commercial property and intangible property (i.e. copyrights, royalties, patents or carbon offsets). Not permitted are loans to members or people or companies connected to the SIPP holder, tangible moveable property (with the exception of tradable gold) and residential property.
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.
Everything you own: all your assets (property, cars, investments, savings, insurance payouts, artwork, furniture etc) minus any liabilities (debts, current bills, payments still owed on assets like cars and houses, credit card balances and other outstanding loans). When you’re alive this is called your wealth; when you’re dead, it becomes your estate.
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.