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Pension Drawdown

Gone are the days when the investments in your pension plan must be used to buy an annuity. ‘Drawdown’ allows the individual to simply spend the money in the accumulated pension scheme by drawing an income from the accumulated funds, while the balance remains invested and can continue to benefit from any continued growth.

Generally speaking, this method of decumulation is only suitable for people with around £100,000 although this will depend on the pension plan, the charging structure and the exact circumstances of the individual.

However with annuity rates at a record low, more and more people are considering whether to use all or even some of their pension plans for drawdown.

The exact rules governing how this is initiated and managed are subject to constant review and adjustment by HMRC, but there are currently two versions, ‘capped drawdown’ and ‘flexible drawdown’.

Capped Drawdown

  • The individual can select an income between 0% and 100% of the single life annuity that somebody of the same sex and age could purchase based on Government Actuary’s Department (GAD) rates – GAD tables
  • With no minimum amount of income that must be drawn, individuals are able to leave their pension benefits untouched for as long as they like
  • Income can be drawn from age 55 and will generally be reviewed every three years until age 75.  From age 75, income must be reviewed every year
  • Capped Drawdown now also allows people to draw the tax-free cash lump sums (PCLS) after age 75 if certain conditions are met

Flexible Drawdown

  • The individual can draw unlimited amounts back out of  the pension plan
  • Care is needed as all withdrawals are treated as earned income in the tax year taken and taxed accordingly
  • Only available to people with > £20,000 of secure lifetime income (e.g. state pension, pension annuity payments) already in payment from other sources
  • Must stop paying into all pension savings plans, so only suitable for people who have finished accumulating capital for use in retirement

Risk

Drawdown carries two main types of risk that need to be managed: investment risk and mortality risk.

Investment Risk: as the balance of the funds remain invested, the responsibility rests on the individual to manage the investments to protect the underlying capital. At each review, the income available will be calculated factoring in the value of benefits and the 15-year gilt yield. If both have reduced, then the available income for the next 3 year period will also reduce.

Mortality Risk: As harsh as it sounds, purchasers  of annuities benefit from the early deaths of other annuity holders. This cross subsidy does not exist with drawdown.

Principal advantages

  1. Tax Free Cash / PCLS can be taken independently of pension income. Those still earning but wanting access to a lump sum can use drawdown in this way
  2. Flexibility – income can be turned on and off as required. This can be helpful for tax planning purposes for those with other assets or income
  3. People who suspect their health will deteriorate can draw income until an enhanced or impaired life annuity becomes available
  4. On death in drawdown, the remaining fund can be used by a spouse in the same way for income drawdown. On the second death, the remaining fund (less taxes) can be left to children as a lump sum
  5. Opportunity to grow retirement benefits evening during drawdown should investments perform well or gilt yields increase

Principal Disadvantages

  1. The individual could run out of money before death! If investment returns are not adequate, then the withdrawals would erode the plan value
  2. Investment into ‘safer’ asset classes such as gilts and cash are unlikely to generate the returns required
  3. Investment into assets that have the potential to generate the returns required to protect the underlying fund value carry additional risk, and are not suitable for the short term
  4. Contract charges can be high on selected drawdown pension contracts
  5. Annuity rates might seem low now, but there is no guarantee that they will not be higher in the future