Income drawdown: a back to basics guide
Unlike an annuity, which allows you to buy a fixed income stream for the rest of your life with your pension fund, an income drawdown allows you to take an income from your pension while it’s still being invested.
What this means is that, in ideal conditions, your fund will continue to grow (or at least maintain its value) while you enjoy the fruits of your lifelong labour.
Of course, this means that your pension fund remains exposed to market forces, and so many retirees will still want the security and stability of an annuity, but for those who want greater control of their finances or are attracted to the flexibility of the pension freedoms, drawdown will be a very attractive prospect.
Types of income drawdown
Prior to the reforms investors could choose capped drawdown plans – here the amount of income you can withdraw is restricted to what could be achieved with the equivalent annuity. This was known as the ‘GAD limit’ and was set by the Government Actuary’s Department. Alternatively if they could demonstrate enough secure income elsewhere they could choose flexible drawdown with no such limits.
Now following the April 2015 changes all investors can choose flexible drawdown – now known as flexi access drawdown and those investors that are already in capped drawdown can switch to the new version. However you could see the amount of money you are able to save into your pension fall from £40,000 a year to just £10,000 so transferring will not always make sense.
Setting up a plan
Typically, personal pensions will offer you a drawdown option as will some workplace defined contribution schemes. If drawdown isn’t available you may need to transfer your pension into one that does, such as a self invested personal pension or Sipp.
Sipps are popular because they offer access to a huge range of investment options – this will appeal to some investors but could prove daunting for others. So if your current pension offers cost-effective drawdown with a reasonable selection of investments there may be little reason to move it.
Justin Modray, founder of Candid Money adds: “Be careful you do not lose valuable benefits from your existing pension such as a guaranteed annuity rate or enhanced tax-free cash and also that you don’t get hit with a prohibitive transfer out penalty.”
Choosing a Sipp
There will be little difference for most investors in the funds offered by Sipps – what should determine your choice will be cost, as well as how easy the platform is to use.
There are two sets of charges to consider: the Sipp provider’s and that of your underlying investments. The numbers may look small but the bigger the charge the more they will erode your pot over time making ignoring them an expensive mistake.
Most Sipp providers charge nothing to open the account, instead they charge an annual management fee – this will either be a flat fee or a percentage of the value of your Sipp.
The key here is that the greater, the size of your pot, the more it makes sense to opt for a flat fee, with £100,000 widely seen as the tipping point.
Next are trading costs. While there are costs for buying and selling individual shares most providers don’t charge you to invest in funds, however the individual funds will have management charges you need to pay. Expect to pay in the region of 0.1% for the cheapest trackers funds, rising to 0.9% for actively managed funds.
How much does drawdown cost?
At the time of writing, with a £100,000 portfolio consisting of 10 funds at £10,000 each (and assuming two fund switches a year), the cheapest Sipp was provided by Cavendish Online/Fidelity, both with a total cost of £300 of year.
The second-cheapest was Alliance Trust Saving's i.inves Sipp, which will cost you £451 in the first year and £326 in the second (consisting of a mix of set-up fees, anuual charges and ongoing dealing charges).
With a £200,000 portfolio of 20 funds at £10,000 each, Alliance Trust Saving's i.nvest Sipp stars again, this time as the cheapest with a total cost for year 1 set at £576 and year 2 at £326.
Coming second is iWeb's Sipp, which will cost you £540 in the first year and a further £380 in the second.
Before deciding which funds to invest in you need to think about what you are hoping your plan will achieve. Are you looking for income, growth or a combination?
If the natural yield isn’t enough you will have to start drawing on capital. This is a much riskier strategy and you will need a portfolio biased towards growth so it can replenish itself over time.
Modray says: “If you draw a sensible amount, typically 4-5% a year then provided investment performance is reasonable you should be okay, but there are no guarantees so it’s important to review income and investment performance at least once a year.”
Dealing with risk
Nobody can predict the way the markets will move, so one rule of thumb is to pick a sensible mix of assets that are unlikely to all move in the same direction at the same time, such as stockmarkets, corporate bonds, property and absolute return funds, which are designed to navigate stormier conditions.
As Laith Khalaf, senior analyst at Hargreaves Lansdown, puts it: “Your first port of call is to decide how much risk you are willing to take, how much income you realistically want to generate and when you might need to draw on your capital. Based on this assessment, if you are longer term and higher risk then you can afford to have more equities in your portfolio. If you have a more medium-term outlook then you perhaps need to dial down equities in favour of safer assets.”
What help is available?
Thankfully there is plenty of help available to help you choose the right funds.
Sipp providers including Fidelity and Interactive Investor have guides to help you select the right funds and make the right investment decisions. There are plenty of calculators too, such as the one available at Hargreaves Lansdown to help you work out how much income you can afford to take.
However if you don’t have any experience of running your own investments then it may make sense to get some professional advice. Getting an IFA to run your porfolio is likely to cost around £150-£200 an hour – but if it saves you making an expensive mistake it could be money very well spent.
Mix and match
It is also important to stress that you do not need to invest all your money into income drawdown. You can annuitise, for example, enough money to cover your bills and leave money for ad hoc expenses to carry on growing in a drawdown plan. Or you can start off in drawdown before switching to an annuity at a later date when rates are better or you have lost the appetite for managing an investment portfolio.
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.
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.
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%.
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.
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.
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
Absolute return funds
Absolute return funds aim to deliver a positive (or ‘absolute’) return every year regardless of what happens in the stockmarket. Unlike traditional funds, they can take bets on shares falling, as well as rising. This is not to say they can’t fall in value; they do. However, over the years, they should have less volatile performance than traditional funds.