‘Even 20 per cent of my fund is better than a letter of condolence from the annuity provider.’ This quote highlights why people should carefully consider income drawdown as an alternative to simply buying an annuity when they retire.

Pensions are strange things. For something that is so valuable and which is going to have a major bearing on how the twilight years are enjoyed, they get scant attention from their owners.

They are the definitive long-term investment, so why they are treated differently to other sums of invested capital is baffling. Most of us would plan carefully how we would invest an inheritance of, say, £200,000, but the majority seems happy to leave similar amounts within pension plans to the whim of an insurance company managed fund.

False assumptions

Pensions are often thought to be complicated, or made to seem more complicated than they actually are. All a pension is in reality is a pot of money that becomes available when you retire and which then replaces the salary that you had drawn when you were working. The bigger the pot, the more you will have to live on. Simple.

So, why is more care not taken in nurturing this pot in the first place? A proper self-invested pension plan (SIPP) – and by proper I mean not a pseudo SIPP, available at some insurance companies, which only offers a range of their own funds to invest in – is a must for anyone who wants to have some kind of influence over the final fund size.

Research by consulting firm Watson Wyatt has shown that pension incomes have fallen by more than three-quarters during the last decade, due to a combination of poor investment returns and a fall in annuity rates. In real terms, this means that if a male had contributed £200 per month for 20 years into an average with-profits pension plan and retired in January 1997 at age 60, he’d be receiving an annual income of £20,513.

Fast forward ten years to January 2007 and this same chap would be retiring on a paltry £4,613 a year, having put in an identical amount of cash as his predecessor.

This is where income drawdown can step up to the plate. For those who are unclear about how this works, it is basically a deferment of buying an annuity while still using your fund to receive payments. There are, of course, pros and cons.

With an annuity, you are guaranteed to receive your set level of income until you die. However, you have to pre-purchase any extras such as spouse’s benefits, annual increases and so on, with each additional feature reducing the amount you receive at the outset quite significantly.

Through drawdown, you postpone having to make this major decision while “drawing” an income from your pension fund (the income being set between upper and lower limits by Government actuaries). This allows your accumulated pot to remain invested and rise or fall depending upon the investment decisions that you take, which is why we should all try to achieve as big a pot as possible in the meantime. Unsportingly, the Government insists that we have to buy an annuity when we hit 75 anyway, but even at 75 the annuity rates that are available should be higher than those for someone ten years younger.

The right decision

The risks are obvious. In the same way that good investments could see the pension fund increase in size even after you’ve started using it, wrong investment decisions could see the pension fund fall, resulting in less money to buy that darned annuity later. However, bearing in mind that most annuities die when you do, it is easy to understand where the person quoted at the start of this column was coming from, as funds in drawdown go back to your estate.

It is pretty clear that if the drawdown route is chosen, you should give yourself as much opportunity as possible of investing the fund without restrictions.

For this reason, I greatly favour a “wrap” account, such as Transact, rather than the contracts offered by insurance companies, who still seem to struggle with the notion that it is your money and not theirs that they are handling. Space prevents me from explaining wraps fully here, but I will look at these in more detail in future months. Feel free to contact me directly for more information in the meantime.

Without getting too evangelical, I implore you to treat your pension funds seriously if you are not doing so already. As with any investment, they need care and attention if they are to keep you in the manner to which you are accustomed in your dotage.