Phase your pension drawdown
After the Budget tax change hurt many pensioners, we highlight a little-known tactic to boost your pension.
If you bought an annuity within the last three years, you were probably very disappointed by the income you were able to get.
There’s a direct link between annuity rates and gilt yields and unfortunately gilt yields have been very low since 2009. Read more on this in How to buy gilts.
Thankfully, we’ve had a bit of good news in the last couple of months because 15-year gilt yields have edged up from 2.59% to 2.85%. So if you buy an annuity now, you’ll do a bit better than you would have done around Christmas. That said, when you look at the big picture, gilt yields are still extraordinarily low.
Given that background, I think people who are approaching retirement should consider an alternative to annuities – income drawdown. Basically it means that you can leave your pot invested in shares or other assets while withdrawing an annual income.
If you decide to go into drawdown, chances are you’ll be obliged to enter ‘capped drawdown'. That means your maximum income will be broadly equivalent to what you would have received from an annuity. For the rest of this article, I’m going to focus on capped drawdown.
One of the advantages of income drawdown is that it gives you more flexibility than an annuity. You’re not locked into the same annual income for the rest of your life.
With drawdown, your income is reviewed every three years at least. So if gilt yields have gone up, you may be able to withdraw a higher annual income after the review. What’s more, if the size of your pension pot has been boosted thanks to stock market growth, that could increase your income too.
Of course, you could lose out if the stock market and annuity rates go against you. What’s more, your pension pot will be depleted as you withdraw cash.
There’s no doubt that drawdown is riskier than annuities, so you shouldn’t consider it if your pension pot is smaller than £100,000. If you don’t want to take any risk, buy an annuity.
But if you are happy to take some risk, you could possibly boost your returns further by going for something called ‘phased drawdown’.
Let’s imagine you have a pension pot worth £200,000 and you’re retiring now. I’m going to look at three possible approaches you could take:
Approach 1: You withdraw £50,000 as your tax-free lump sum and use the rest of your pot to purchase a conventional, bog-standard annuity*. As a 65-year old man, you’re able to get an annuity of around £9,000 a year. (Check what income you could get using our annuity calculator.)
Approach 2: You withdraw £50,000 as your tax-free lump sum and put the remaining £150,000 into drawdown. This allows you to withdraw £8,700 a year initially.
If you die while you’re in drawdown, your remaining pot can be passed to your family subject to a 55% tax grab by the Government.
Approach 2 has two advantages over Approach 1.
Firstly, your remaining pot may grow if your investments do well. Secondly, if you die, your family will receive some of your pot whereas if you had bought an annuity, your family would get nothing.
Approach 3: Instead of cashing in your total £200,000 pot, you only cash in £30,000 for drawdown. Both the £50,000 and the remaining £150,000 can stay invested, it’s just that the £150,000 isn’t part of the drawdown plan at that point.
You then withdraw £7,500 as a tax free lump sum, and you take the maximum permitted income from the remaining £22,500 – that works out at £1,305 a year.
If you use the tax-free lump sum as income, you’ll then have around £8,805 to live on that year (£7,500 + £1,305). This is the gross amount of income you need for the next 12 months.
When you get to the end of the year you can then decide the income you need for the next year and repeat the exercise which will take account of gilt yields at that time. You will already have £1,305 of income available.
Both the £22,500 and the remaining £170,000 can stay invested, it's just that the £170,000 isn't part of the drawdown plan at that point.
Approach 3 has two advantages over Approach 2.
Firstly, there will be no tax to pay on the remaining £170,000 if you die over the next year. Your family will still have to pay 55% tax on whatever portion of the £22,500 hasn’t been drawn down at your death.
Secondly, you can trigger a review of your maximum permitted income levels at any time. You can do this by ‘designating’ as little as £1,000 for drawdown. You’re just moving £1,000 from the £170,000 pot to the £22,500 pot.
As Adrian Walker from Skandia comments: “Holding just a small amount back from a pension, and feeding it in at a later date, could increase a person’s income where the gilt and/or stock market has improved. Importantly, the entire pension can benefit from any improvement in maximum income calculations if the pension arrangement is structured in this way.”
So if you see that stock markets and/or gilt yields have moved upwards, you can quickly trigger a review and boost your maximum income.
Of course, if you live for some time, you’ll have to cash in all of the £150,000 at some point to sustain your income.
But the point is that by ‘phasing your drawdown,’ you can make sure that you get the best maximum income available at any time, and you reduce the tax bill on your pension savings should you die during the period.
Just remember though that the maximum income might fall and you could get caught out eventually. If you want to reduce the risk at some point, you could always buy an annuity and secure your future income at that point. That could be a more attractive option were annuity rates to rise.
Now I admit this is all quite complex, so if you think phased drawdown might work for you, I’d urge you to get advice from a competent financial adviser or an accountant.
And if you like the idea of ‘phasing’ but want to do something a bit simpler, you could consider a fixed-term annuity.
*This is a level, unenhanced annuity for one person with no guarantee.