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If all this money that was going into annuities now isn’t, where is it going to go? For most, probably nowhere initially, because there is an alternative option known as Pension Drawdown. With this option, you can still take your tax-free lump sum, but instead of buying an annuity with the rest of the fund, you can leave it in the pension. You would do this because you can then leave the money growing tax-free and draw an income from the proceeds. Let’s look at what opportunities this option gives you that an annuity doesn’t.
The first opportunity is that you can increase, decrease, stop and start your income. You can take your tax-free lump sum anytime from age 55 but could initially decide to set your income to £0 if you were still earning an income. This allows your money to continue to grow and avoid adding an extra income that would be better deferred, so that you don’t pay more tax than is necessary. You might decide that you want your income to increase gradually over those early years of retirement, particularly if you are phasing in your retirement—maybe decreasing to three days a week, then two days, as is often the case now. This could be done by gradually increasing the income if you’ve taken the tax-free lump sum already, or by taking the tax-free lump sum gradually. The latter idea would allow you to take this extra income, without paying any extra tax—a really good idea if you are still a higher-rate tax payer.
This ability to increase and decrease your income allows you to plan much more effectively. You could plan to have a few extravagant years at the start of your retirement, which we will look at later on, or if you have started your own new business, you can draw the income you need to top up those variable earnings.
This income is taxed in the same way as an annuity income is, but it offers more flexibility to minimise the tax you pay. Perhaps more important than that, though, is that whatever is left on your death is able to pass to your children. None is lost to the very hungry life insurance companies that provide annuities, and all or most of your remaining savings will go to the people you love most. There may be some tax for them to pay, but this will depend on how old you are at the time of death. Even if they inherit 60% of the value of your pension, they will consider this to be better than zilch!
The risk of drawdown is that the funds remain invested. If those investments were to fall, so could your income. If you take too high an income, or the investment performance is worse than you forecast, you could run out of money. Of course, there is still the State Pension to fall back on, but as we have already established, this is not a large amount of money. As a result, it is important that you treat drawdown with more caution than you would when buying an annuity—if you don’t get the investment strategy right, it will cost you dearly.
The risks of drawdown mean the strategy won’t be appropriate for everybody. It also means most people will need ongoing investment advice, so it is important to get the right type of solution that meets your needs. Your planning will also become far more important. You don’t want to run out of cash, but you also don’t want to be the richest man in the graveyard, so planning and monitoring your investments versus the income you are taking is vital to success. As long as you follow these guidelines, you can maximise your retirement funds during the years you can enjoy them the most, and ensure that what is left over can pass down to your family.
It’s worth taking a moment to think about the drawdown risk. Understandably, people can be uncertain about ‘gambling’ with the income they will rely on for the rest of their lives. Particularly if you have been employed for your whole working life, you have learnt to rely on a fixed regular ‘guaranteed’ income. The idea that a rubbish pension is all that stands between you and losing that income fills a lot of people with dread. Have a figure in your head for the income that you will need in retirement.
Create a breakdown of expenses so you can have an idea of your target retirement income. Now start to think about this in relation to a lump sum of money. You could purchase an annuity to secure you a set level of income that could perhaps be higher than this. Alternatively, as we’ve talked about, you could hang onto this lump sum of money and draw an income from the returns and from the capital. The worry is, of course, whether the money will run out. Will those overpaid fund managers deliver on the returns you need to live off this money for the rest of your life? Think about your capacity for loss, and also for your loss of returns.
When looking at drawdown as an option, you need to be aware of the risks and continue to monitor them, either yourself or through your trusted adviser. Drawdown is not final. With a traditional annuity, you have made your final call; however, with drawdown you always have other options. You can always buy an annuity at a later stage. At this point, you could still buy an annuity to ensure that income was then paid for the rest of your life.
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