The new income drawdown rules – the opportunities and risks for investors

26th March 2014

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Amid all the hoohah and headlines around the Budget’s promise of “pensions freedom” – as well as the subsequent debate over how loveable and liveable this liberty is – few noticed technical changes that dramatically enlarge the number of those who can already be free of compulsory annuitisation. Tony Levene examines the issues.

On Thursday 27 March, new rules will allow many more to put pensions into “income drawdown”, a scheme which avoids or delays annuity purchase. Drawdown leaves you with control of your own pension pot and able within current limits to take income as you wish. These limits have now been eased, making both forms of income drawdown – capped and flexible – more accessible.

Capped drawdown

Capped drawdown allows taking pension benefits without an annuity. Holders can take the 25 per cent of pension pot tax free lump sum, and then an annual income up to a set amount, leaving the balance of the fund to grow (or if the investment strategy goes wrong, to shrink). You effectively use the pot, which is still in a tax free environment, as a source of spending money, withdrawing any amount from nothing to the limit.

The limit is set by GAD. Put this acronym into a search engine and most results point to Generalised Anxiety Disorder, a condition involving excessive worrying or an inability to relax.

But although that sounds like pensions planning, this GAD is the Government’s Actuary’s Department. It sets the maximum capped drawdown participants can take from their fund. This was set at 100 per cent of a standard annuity until recently. Someone with £100,000 after their tax free lump sum could take – depending on age – either a level income of say £5,900 for life or up to £5,900 a year from their fund. This income is taxable whether as drawdown or annuity.

The drawdown fund remains in a self invested pension plan (SIPP), a solution for those who believe they can grow remaining funds rather than hand them over to an annuity company and – because the drawdown can vary down to zero – it is useful for those with other variable income sources. An author, for instance, might get high royalties just after a book is published and low amounts while the next is in the writing process. This flexibility can prevent earnings drifting into a higher income tax band.

Last year, the GAD rate increased to 120 per cent, offering fresh planning possibilities. And from this Thursday, new capped drawdown customers can use 150 per cent as their upper limit.

This table – from Hargreaves Lansdown, based on current government stock yields used as a basis for annuity pricing, shows the effect.

 

Maximum income

 Age

100%

120%

150%

60

£5,300

£6,360

£7,950

65

£5,900

£7,080

£8,850

70

£6,900

£8,280

£10,350

Source Hargreaves Lansdown
NB Based on current month’s Gilt yields

Higher limits, if used, will deplete the fund faster, needing a better investment strategy to prevent the pot running out of cash.

New investors can start now with the higher levels. Existing drawdown holders must wait until the next policy anniversary – up to 12 months for some.

Flexible drawdown

This allows pension pot holders to take as much as they like provided they have a basic guaranteed income from other sources. While it currently applies mostly to those with substantial pension pots, the withdrawal facility is a potential model for the end of annuities world starting in April 2015.

There is no GAD rule although big withdrawals are penalised by higher rate tax charges.

On Thursday the minimum income is cut from £20,000 to £12,000, offering the scheme to many more. This income must come from secure sources – generally the state pension, a final salary occupational pension or an existing annuity.

“A married couple on the state pension plus some state second pension would be already a long way to qualifying,” says pensions analyst Danny Cox at Hargreaves Lansdown. “The height of this hurdle has come down a very long way.”

Drawdown drawbacks

Once withdrawals start, no more money can be invested in the fund. But those with large incomes can set up another plan.

Once drawdown starts, anything left upon death is taxed at 55 per cent (compared with inheritance tax at 40 per cent).

Drawdown plans generally involve higher charges than annuities – especially for smaller sums.

The unused portion of the fund is susceptible to poor investment decisions or to general financial market setbacks while annuities are secure for life.

If you later decide you want an annuity, it might be even worse value than on retirement.

Drawdown discipline

One of the fears of those criticising the planned pensions freedom is that pensioners will run out of money – either they will spend it all on a Lamborghini (the average £30,000 pension pot will just about buy a couple of wheels) or they will withdraw it too fast or they will gamble it away on high risk investment strategies. The tax system where individuals pay the rate for the pension withdrawal on top of their other income will act as a brake – too big a withdrawal in a year will result in a higher or top rate charge.

Whatever the rules allow, the pension pot must last a lifetime – and possibly that of their partner as well.

Tom McPhail at Hargreaves Lansdown says: “Investors must remember new income limits haven’t changed the fundamentals of investing. If you draw the maximum income, you will probably run down your pension fund. Our default recommendation to take a sustainable, rising real income is to invest in a good spread of predominantly equity based funds and to take the ‘natural yield’ from the investments as income. That means the income payments made from the underlying investments; dividends in the case of shares; the interest payments from bonds etc.”

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