Income drawdown suddenly looks like the best thing since sliced bread for millions of Britons who need to plan their retirement income. But failing to get the balance right between income and investment performance could spell disaster for the unwary.
With UK annuity rates at 300-year lows, the advent of the new-look ‘flexi-access’ drawdown as it’s now known couldn’t have come at a better time. It’s now two years since the so-called ‘pension freedoms’ were introduced in April 2015. This new set of rules removed many of the previous impediments to managing your own pension pot in retirement and created the best playing field yet for UK pension investors.
Income drawdown for the masses
Today, anyone over the age of 55 can make use of income drawdown to manage how they invest their pension pot and how they choose to take their pension benefits. There’s a virtually unlimited combination of income and lump sum withdrawals available as well as the opportunity to simply cash in your whole pension pot – however large or small it may be – subject to the tax rules.
The new rules also make personal pensions one of the most tax efficient ways in which to pass assets to your chosen beneficiaries as well as offering the genuine opportunity to reduce the level of tax you end up paying retirement.
Of course, there’s a ‘but’. And it’s a pretty big one at that.
The risk of being ‘ravaged’
The single biggest worry for the army of Britons that’s now pinning its retirement hopes on income drawdown is that drawdown transfers the risks of delivering an income in retirement directly on to your shoulders.
This means that, if your investment choices perform poorly and you continue to draw a level of income that’s, frankly, beyond your means, your pension pot could become permanently depleted and dry up long before you do!
This combination of disappointing investment returns and a withering level of withdrawals is known as ‘sequence of returns risk’ or, more dramatically, ‘pound cost ravaging’.
To help Britons get to grip with this risk Drewberry have created an Income Drawdown Calculator. It’s a priceless companion for anyone who’s either considering or already embarked upon income drawdown. It’s a mercifully simple to use online tool that will calculate the level of monthly income you can afford to take without depleting your pension pot.
Alternatively, you can use it to illustrate just how long your pension pot is likely to last given a set level of monthly withdrawals or to work out how large a pension pot you’re likely to need based on your ideal monthly income. And there’s no limit to how many times you can use it.
Once you’ve gotten to grips with the risk of ‘pound cost ravaging’ and established a drawdown strategy that will prevent your hard-earned pension pot from evaporating before its time, there are no end of potential benefits to income drawdown.
Sharing the wealth
Thanks to the pension freedoms, once you’ve ensured that your pension pot is as safe it can be from being ‘ravaged’, you can now pass on any remaining pension wealth to your loved ones without having to pay the punitive 55% ‘death tax’ that was previously in place.
Now if you die in drawdown before reaching age 75, your whole pension pot can be passed to your loved ones free of tax. They can either continue drawdown and enjoy the income free of tax, or they can purchase an annuity, the income from which will likewise be tax free.
If you die after age 75, your beneficiaries will be liable to income tax at their marginal rate when they come to draw the benefits. However, there’s nothing to prevent them from keeping the funds invested and deferring when they take the benefits until it’s more tax-efficient to do so.
Combined with the fact that pension assets have always been free of inheritance tax (IHT), the timely death of the ‘death tax’ suddenly made drawdown one of the most tax-efficient ways in which to pass wealth down through your family.
This is a real shot in the arm for the millions of middle-class families in this country who are slowly coming round to the realisation that they have significant inheritance tax bills in their near future.
This ability to pass on your pension wealth has, alongside skyrocketing transfer values, helped to trigger the current boom in final salary pension transfers. This is because, just like an annuity, a final salary pension will be lost once you (and possibly your spouse) die.
Transferring to drawdown
Although they’re rightly regarded as ‘gold plated’ there are two key drivers of the current boom in final salary pension transfers. The first is clearly the record transfer values that are now on offer from the UK’s embattled final salary schemes thanks to the virtual collapse of UK gilt yields.
If you’re one of the lucky 6.8m1 or so Britons with deferred rights to a final salary pension you could be sitting on a proverbial gold mine right now. Simply put, the cost to your old employers of providing you and your spouse with an inflation-linked pension for life has hit an all-time high. By extension, this has pushed the cash equivalent transfer values (CETV) – namely the cash payments that final salary schemes offer as an alternative to drawing your pension – into the stratosphere.
The last few years have seen the transfer values offered by many final salary schemes double or even triple in real terms. And the sums involved can be truly life changing.
As a broad rule of thumb, if you live outside of London and have a final salary pension entitlement of anywhere near £10,000 a year, there’s every chance that your current pension transfer value is worth a lot more than your house!
For example, we recently helped a client in Scotland to assess a potential transfer and we found that his relatively modest pension entitlement translated into a transfer value that was almost three times the current market value of his home.
Keeping what’s yours
While such sky-high transfer values have triggered the current stampede in final salary pension transfers, it’s been helped along the way in no small measure by two important shortcomings of the final salary regime that have been highlighted by the pension freedoms.
The first is that although those lucky enough to enjoy final salary pensions can rely upon a guaranteed, usually inflation-linked income, they’re also likely to be paying more tax than if they were to transfer to a personal pension arrangement that allows them to utilise income drawdown.
More pertinent is the fact that, like those who purchase an annuity in retirement, if you’re drawing a final salary pension your entire pension wealth disappears into the ether once you and your spouse die.
By contrast, transferring your final salary pension to a personal pension and making use of income drawdown will convert it into a major financial asset that can be passed down through successive generations of your family.
Think of it this way: How would you feel if you were told that you couldn’t bequeath your home to your chosen beneficiaries because, due to some odd regulations, its value just mystically ‘disappears’ when you (and your spouse) die?
But this is exactly what happens to all the value in your final salary pension scheme (or your annuity) once you and, usually, your spouse dies – even though it could be worth a lot more than your house!
As more and more people wake up to what’s at stake with their choice of pension contract and the very real opportunity to create and protect lasting wealth that can be passed down from one generation to the next, ever greater numbers of Britons will be opting for income drawdown. So it’s best to start reading up.
1 Royal London, data correct as at March 2015. Sources: Purple Book (December) 2015 & LGPS Annual Report 2015.