Don't leave it to pot luck

People retiring now face a double hit. Interest on their savings is tiny, especially if they do not move their money every year. And the income they can buy with their pension fund has never been so low. A healthy 65 year old man or woman will be lucky to get £6000 a year from a pension pot of £100,000 and the average pot is around £25,000 which will give a pension of well under £1500 a year.

One reason for these problems is the success of the UK government in controlling public spending. Commercial investors see lending money to the UK Government as a safe investment – not least because the UK is very unlikely to default as Greece has and others might. As a result the interest the Government has to pay to borrow this money is coming down. It is currently little more than 2%. It is that return on Government bonds (and forecasts of life expectancy) which determine the amount paid by insurance companies when you convert your pension pot into an income for life – called an annuity. So the pension you get for £100,000 pension pot is falling. In June 2008 a pension pot of £100,000 would have bought an income for life at 65 of almost £8000. Today that has fallen by a quarter.

One alternative to low annuity rates is to take regular money from your pension pot. It is called ‘drawdown’ and an estimated 50,000 people a year choose to do that. Before April 2011 there were two sets of rules – one for those aged 55-74 and another tighter regime for those aged 75 or more. Now there is just one set of rules – which is better for the over 75s but worse for those under that age.

Capped or Flexible
Anyone with a guaranteed income from other sources of at least £20,000 a year can take any amount out of their pension pot – called ‘flexible drawdown’. The money will be added to income in the year it is taken out and tax will be due on it. If you are over 65 and the drawdown raises your income above £24,000 you will begin to lose your higher personal allowance – in effect some of the extra income will be taxed at 30%. And once your income exceeds £42,475 the excess will be taxed at the higher rate of 40%.

The income that can count towards the total of £20,000 guaranteed income is limited to a pension from an employer, the state pension, a lifetime annuity or an overseas pension. You cannot count earnings, rent or any other income towards this £20,000 limit as none of them is guaranteed. If you have slightly less than £20,000 then you can split a pension pot and buy an annuity with part of it to make sure you have above £20,000 income and then the rest of the pot can go into unlimited drawdown.

The great majority of people have a guaranteed retirement income which is far less than £20,000 and the amount of drawdown is capped. This cap depends on three things – your age, your sex and the yield on Government bonds. At the time of writing the yield on 15 year bonds is 2.58% which is rounded down to 2.5%. That amount is put into tables published by HMRC which show the amount you can draw down. As things work out this amount is currently rather less than you could get from the best annuity on the market – about 6% less at 65.

These figures for drawdown are far less than those I put in a table 18 months ago in Saga Magazine. Two things have reduced them. First, the falling return on Government bonds. Second, before 2011 people under 77 could take around 120% of the amount that a standard annuity would pay. From April that was cut to around 100% - and in fact the way the numbers are worked out it is rather less than that at the moment. This table shows a flat-rate, single life annuity with no guarantee for someone in good health living in the south of England. With some providers the Annuities may be higher in some parts of the UK.

Reviews and costs
Drawdown plans begun before 6 April 2011 are automatically reviewed every five years. The falling value of annuities and the cut from 120% to 100% means that when those amounts come up for review the income that individuals in those drawdown schemes can take out will be a lot less – in the worst cases barely 60% of what it was even if their capital has remained the same. If capital has fallen, as it usually will have done, it can easily be halved.

Anyone who begins drawdown from April 2011 will normally have the amount they can withdraw reviewed every three years. At the review your income may fall. First, your capital may be less if the returns minus charges have not kept up with the amount you have been drawing down – and if you draw the maximum that is quite likely. Second, at the review the latest tables will be used which could mean your rate of income per £10,000 will be changed – up or down.

Remember that as you get older your health may worsen which could mean the annuity you get would be higher than the normal rates. So drawdown can be useful for a while but always review it yourself periodically to see if it is still a good idea.

To drawdown rather than buy an annuity you have to put your funds with a drawdown provider. You can find one through an Independent Financial Adviser or the internet. The provider will charge you for holding your money and doing the administration with HMRC. That charge will probably be in the region of 1% to 1.5%. And if you want advice about where your money is invested you can add another 0.5% at least. Take care, some are very expensive. Generally it is best to go for the lowest charges as no provider will make any guarantees that it will achieve anything by charging you more.

Drawdown choice

AGAINST

·         You may get less income than an annuity would provide. That is especially true if you are a smoker or have health problems.

·         You will have to pay charges to the drawdown provider.

·         Your income may fall every three years and you may run out of money before you die.

·         You need around £200,000 or more if drawdown is your only retirement income. If you have other secure income or substantial savings you can do it with a far smaller amount.

FOR

·         You do not give up your capital and can leave what remains to your heirs.

·         You avoid making a once and for all decision about how to convert your pension pot into an income.

·         You can change the amount of income you draw as your needs change (within the limits if other pension income is less than £20,000).

·         You can buy an annuity at any time when rates improve or your health deteriorates.

More information
Pensions Advisory Service http://www.pensionsadvisoryservice.org.uk/annuities-and-income-drawdown or call 0845 601 2923

e-mail Paul Lewis on paul@paullewis.co.uk