Wealth

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Income drawdown shocks ahead

Since their introduction in 1995, drawdown pension plans have been widely  regarded as an alternative to the traditional lifetime annuity. Many welcomed  the option to unlock tax-free cash without taking out an annuity while others  were attracted to retaining ownership of the funds and the flexibility of the  policy with regards income levels and lump sum death benefits

The disadvantages of annuities are well documented. Your income is tied for life to the state of the market (currently depressed) at the time you take out the annuity and, when you die (even if only a day after taking out the annuity) your estate gets no further benefits

Arguably, sales of drawdown plans peaked in 2007, which coincided with the FTSE  100 Index hitting a high of 6,730 during June 2007. Five years on and Summer  2012 will see many clients approaching their fifth anniversary and their first  formal maximum income review, and many may well be in for a shock, seeing their income plummet by as much as 50%

Why?

So what’s happened during the past five years to cause this significant downward  pressure on the income available from drawdown policies

Basically, three things have combined to produce this ‘perfect storm':

- falling stock markets,
- rule changes
- yields on government debt hitting historic lows

Falling stock markets - Since 2007, stock market-linked investments have experienced dramatic  fluctuations in their values. Shortly after the highs of June 2007, the impact  of the banking crisis and the credit crunch took hold and the FTSE 100 fell to a  low of 3,512 in March 2009. Although the FTSE has steadily recovered since then  it still remains around 10% lower than it was in 2007

Rule changes - Before  April 2011, those in drawdown pensions could take a maximum of 120% of a comparable annuity rate. So, someone who might expect to get an annuity of £10,000 a year would be able to withdraw a maximum £12,000 in drawdown. In April 2011, the government changed the rules to allow a maximum of only 100% to be taken, amid fears that pensioners could be running down their funds too quickly. In addition, the Government Actuary’s Department (GAD) tables were revised so drawdown rates reflect increased longevity. This will cut the maximum income pensioners can take still further

Yields on Government debt - The maximum annual income that pensioners can take is based partly on the  yield on 15-year government bonds (gilts). This peaked at 5.25% in July 2007. However, gilt yields have since plunged to 2.75%. One of the main reasons for this has been the successive rounds of quantitative easing by the Bank of England. The Bank’s decision in February to print another £50 billion is likely to have reduced further the amount of income that pensioners can take from their funds through drawdown because the money was used to buy gilts, thus reducing the yield. Any further rounds of quantitative easing would be very bad news for those on drawdown

So what?

When people entered drawdown five years ago, gilt yields (in July and august 2007) were 5.25%. Anyone having their income set at this time, and will have have it set using a very high gilt yield and using the 120% maximum income limit. At their 5 year review, the maximum income will be 100% and the gilt yield will be  much lower. Add in the fact that investment returns have generally not been that great, and that’s why there will be very large falls in income for  thousands of people

So a man who was then aged 62, and who entered drawdown in August 2007 with a £100,000 pension fund, could have enjoyed a maximum annual income of £8,640 — or £720 a month. Now, when he comes up for his five-year income review this summer, the maximum he would be able to take would fall to £4,190 — or £349 a month a 52% cut in income, presuming yields remain at their current depressed levels. And he would have to stick with that level of income until his next review, even if the stock market surged and Government yields increased

Is there anything I can do if I’m up for review?

One strategy is to top up the shortfall with other savings and request another review in a year, hoping conditions will have improved by then. Your provider may or may not agree, but in any event, reviews will now be carried out  every three years going forward

Another strategy is to exit drawdown altogether and opt for an annuity instead. Experts counsel against doing this either all at once, or fully. In other words you can keep some of your pension in drawdown and phase in the buying of several annuities over the next few years with the remainder in order to achieve a balance

What if I’m approaching retirement?

The above is perhaps the best approach if you want both security and flexibility i.e you could use only part of their fund to buy an annuity while moving the rest into drawdown. This gives you the flexibility to use some or all of your drawdown fund to purchase a further annuity if and when security of income becomes more important

Remember that annuity income has also plunged in line with gilt yields. In July 2007, a 62-year-old man with a £100,000 pension pot could get a pension of £6,940 a year, if he bought a single-life, level annuity. That’s fallen to just £5,750 today — a 17% reduction. The income for a 65-year-old man has fallen from £7,390 in July 2007 to £6,189  today. Despite some rate improvements recently, you should consider phasing your annuity purchase to avoid fixing your entire retirement income using rates on a particular day

While one of the attractions of drawdown is that you retain control of  your funds and can pass them on to your heirs — unlike an annuity, where any remaining pot dies with you — a new tax charge was introduced last year  taking 55%, rather than 35%, of any remaining assets on death

As with all matters financial, make sure you seek independent professional advice before entering drawdown and/or annuity

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