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SIPP income drawdown – the secret option?

When you want to take benefits from your Personal Pension the choices are to take your tax free cash sum – almost always 25% of your fund – and, with the rest of your fund, either buy an annuity from your current provider or shop around and buy it with whoever quotes the best annuity rate.

There’s another option not always mentioned: DON’T buy an annuity. Take Income Drawdown.

So what’s the difference?

Technically there are quite a lot of distinctions but in essence:

• With an annuity you give your fund to an insurance company and get a guaranteed income.
• With Drawdown your pension scheme pays your income but keeps hold of the fund.

Will Drawdown produce a better pension?

You can take perhaps 20% more than a typical annuity rate for your age, but really it’s more about flexibility, being able to adapt your pension to changing circumstances, and keeping control of your funds. However if they perform well you could end up with a far better pension.

Is there a risk?

Only if there is an imbalance between the pension you are taking and the performance of your fund, but then you wouldn’t put Drawdown funds into high risk investments.

An annuity is rock solid but you pay a lot for the certainty. For many years annuities have worked well but now, due to longer life expectancy and lower investment returns, the annuity per £1000 of fund has dropped so sharply that annuity providers are now just doling out misery.

An annuity carries a risk too: not in the consistency of its payments but in being locked into a rate that reflects financial conditions which might not have been ideal, and which can never be improved.

Is Income Drawdown, like an annuity, a lifetime commitment?

Not at all. You can’t buy an annuity then exchange it for Drawdown, but you can stop Drawdown at any time and buy an annuity with the remaining funds.

You may only want to take Drawdown for a few years, until the financial climate improves or you can benefit from better annuity rates as you get older or, in the unhappy event of your health deteriorating, you could buy a special annuity that reflects your circumstances.

When you reach 75, current legislation resulting not so much from logic but as a political sop to the insurance companies, may make it preferable to buy an annuity if you haven’t already done so – but take advice!

Is Income Drawdown suitable for everybody?

Most of the people whose circumstances are inappropriate for Drawdown probably wouldn’t take out a SIPP. Besides purely financial considerations the same psychological influences apply, such as attitude to risk and enthusiasm for managing one’s own affairs. There are people for whom Drawdown is eminently suitable and those for whom it isn’t. Let’s start with the latter:

• People with small funds; less than, say, £80,000 in total
• Where a small pension is the only or main source of income
• People who wish to avoid any sort of risk
• People who might qualify for a special annuity e.g. for smokers or impaired lives
• Those who need a fixed income, either for themselves or dependents

And the circumstances favourable for Drawdown:

• Those who can afford to take a measured risk in place of a dull certainty
• As an interim measure, allowing immediate income without commitment to an annuity
• People whose circumstances change and might, for instance, want to take maximum pension in one year but nothing the next
• Where an asset can provide the income, such as rent from a property
• People who don’t want to spend Protected Rights funds on a rigid Protected Rights annuity
• Those prepared to actively manage their funds

How does Income Drawdown work?

Annuities are based on annuity rates, which depend on age, sex and the type of annuity e.g. whether it increases or includes a spouse’s pension. To calculate the pension you apply the rate per £1000 of fund to the amount of funds available– and that’s it for life.

The maximum Drawdown pension is based on Government Actuary’s Department tables – known as GAD rates – which like annuity rates vary according to financial conditions. Calculation of the pension, which is a level pension with no extra’s, is the same as for an annuity and the resulting amount will be similar to a typical annuity. However 120% of the “GAD pension” can be taken.

The pension is reviewed at least every 5 years. The fund is valued and the GAD rate applied for the current age to show the new maximum pension. This continues until age 75.

Can Income Drawdown continue after age 75?

Yes but in a more restricted form. The maximum percentage becomes 90% and the GAD rate for age 75 applies regardless of age, so the annuity alternative becomes progressively more attractive.

The situation becomes complex on death particularly if there are no dependents and possible Inheritance Tax involvement. The tax penalties effectively criminalise the holding of funds in these circumstances.

Please consult with your Financial Advisor before considering if Income Drawdown is suitable for your requirements.

Jun 30, 2008