When preparing for retirement, the various options on offer can seem daunting. Jenny Lowe considers the benefits and drawbacks of opting for income drawdown.

Pensioners funding their retirement through income drawdown are bearing the full impact of the Bank of England’s quantitative easing as falling gilt yields continue to drag down people’s income.

Since the announcement was made on the 5 March last year that the Bank of England was to inject £75 billion into the UK economy with the purchase of corporate and government bonds, the yield on 15-year gilts, used to calculate the amount an individual can take from a pension fund, has fallen dramatically.

Vince Smith-Hughes, head of business development at Prudential, points out, ‘Falling gilt yields mean less money for individuals approaching retirement who are considering income drawdown. They may begin to feel a bit like the walls are closing in on them as far as their retirement income options are concerned.’

Staying invested
Income drawdown allows investors to keep their pension funds invested beyond their normal retirement date. They draw an income from this fund, hoping that superior investment returns will give them a bigger pot of money with which to buy an annuity by the age of 75.

It is an alternative to an initial purchase of an annuity, which involves handing over your pension savings to an insurance company in exchange for a guaranteed annual income for the rest of your life.

‘You continue to manage and control your pension fund and make all the investment decisions,’ explains Tom McPhail, head of pensions research at Hargreaves Lansdown. ‘Providing the fund is not depleted by excessive income withdrawals or poor investment performance, there is also the opportunity to increase the income taken as you get older.’

Since income drawdown became available back in 1995, more than 180,000 people have taken out a contract that enables them to draw an income from their pension fund. So how do they work?

‘Firstly, you decide how much of your pension fund you want to move into drawdown,’ says McPhail. ‘Then you can normally take a 25 per cent tax-free lump sum and draw an income from the rest.’

You can choose to take income from your pension fund from age 50 (55 from 6 April 2010). The government sets a maximum limit on how much you can take as income in any 12-month period from an Unsecured Pension. However, there’s no set minimum, which means that you could actually delay taking an income if you want to and simply take your tax-free cash lump sum. The amount of yearly income you take must be reviewed at least every five years.

From age 75, income drawdown plans are subject to different government limits and become known as Alternatively Secured Pensions (ASPs). If you’re already receiving income from an income drawdown plan then when you reach the age of 75 it will become an ASP. But you will still be able to receive a regular income while the rest of your fund remains invested.

What are the risks?
It is important that you understand the biggest risk of income drawdown. That is that your fund could be significantly, if not completely, eroded in adverse market conditions or if you make poor investment decisions. In the worst case scenario, this could leave you with no income during your retirement.

McPhail also points out that investors should be mindful of the impact that withdrawals, charges and inflation will have on the overall fund: ‘Anyone considering income drawdown needs a significantly more adventurous attitude to investment risk than someone buying a lifetime annuity. Lower-risk investments may struggle to keep pace with the income you withdraw, while higher-risk investments could mean that the capital will be subject to large fluctuations.’

Think ahead
You should also take longevity into consideration. No-one likes to give serious thought to the prospect of dying, but those with a significant chance of passing away during the early years of their retirement may well fare better with an income drawdown plan because it allows the pension assets to be passed on to dependents.

Jonathan Howard, head of corporate clients at Courtiers Wealth Managers, explains, ‘A spouse has a number of options when it comes to the remaining vested fund. The spouse can continue within income drawdown until they are 75 or until the time that their deceased spouse would have reached 75, whichever is the sooner. Any income received from this arrangement would be subject to income tax.

‘By taking the fund as a lump sum, the spouse must pay a 35 per cent tax charge. In general, the residual fund is paid free of inheritance tax, although HM Revenue & Customs may apply this tax.’