What is income drawdown?

Updated on 25 February 2015

Income drawdown means keeping your money invested for longer. But is that a smart thing to do with your pension?

The income drawdown alternative

Recognising that some pensioners prefer not to be forced to buy an annuity, pension providers have experimented with various alternatives that allow retirees to generate income while keeping hold of their pension pots.

By far the most popular alternative to annuities is income drawdown. With income drawdown, instead of giving away your pension pot in return for an annuity, you keep your pot invested in the hope that it will grow tax-free over time.

As income and capital gains build up in your pot, you dip into it for income. This income can be fixed (known as capped drawdown, and limited to 150% of the value of an equivalent annuity) or variable (but you must show you have at least £12,000 a year of other pension income), up to an agreed limit.

There are four main advantages of income drawdown.

  1. You aren't forced to buy a lifetime income when annuity rates are low and permanently surrender your fund to an insurance company.
  2. You choose how much income to withdraw, subject to limits set by the Government Actuary's Department (GAD), although these limits will be scrapped from April 2015.
  3. Your pension may continue to grow in value, boosted by tax-free income and capital gains.
  4. You can pass on pension funds when you die by gifting a lump sum or income to your dependants.

You can withdraw up to 25% of your pot as a tax-free lump sum.

The danger of a shrinking pot

Obviously, plunging stock markets and falling asset prices reduce the value of pension pots, which is why income drawdown is much riskier than buying an annuity.

Right now, the limit for income drawdown works out at between 6.15%-95 a year, depending on how old you are. However, withdrawing an income this high could deplete your fund and put your future income at risk.

For instance, American financial guru William J Bernstein calculated that, based on a fixed withdrawal rate of 6% a year, most pension funds would be completely wiped out within 18 years. However, with a withdrawal rate of 4% a year, almost all portfolios last more than 30 years.

That's why experts such as Danny Cox of investment managers Hargreaves Lansdown warn that the most favourable withdrawal rate for income drawdown is at most 4% a year. At this rate, a pension pot valued at £100,000 would generate yearly income of £4,000.

So if you're interested in income drawdown, always play it safe. Don't withdraw too much in any given year, and be prepared to accept a lower income when your pot shrinks.

The low-cost route to income drawdown

Income drawdown is best suited to long-term investors who are willing to take some risk with their pension pots in return for higher incomes in future.

For pots worth £100,000 or more, income drawdown is well worth considering, despite the extra fees, higher risk and increased complexity of drawdown. On the other hand, if your pension pot is valued at under £50,000, then an annuity is almost certainly the best option.

Currently, about 200,000 pensioners use income drawdown to generate income from their pension pots. Of these, most do so via low-cost, flexible, do-it-yourself pensions known as SIPPs (Self-Invested Pension Plans).

Changes coming

From April 2015, you will be able to withdraw as much or as little of your pension as you like. You could choose to use drawdown or a combination of annuity (which guarantees you an income) and drawdown.

If you're thinking of drawdown, you may want to seek independent financial advice.

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