Retirement Options - Phased Drawdown

When many dentists reach retirement age, they are lucky enough to have a substantial NHS pension, from age 60, based on their practitioner income or final NHS salary. For those that have also invested in a personal pension they will need to make some decisions as to how they are going to take the income. Typically, 25% of the fund can be taken as tax free cash (now known as the pension commencement lump sum) and the remainder is taken as a taxable income.
Many people simply take the default option of an annuity with the same pension provider or take advantage of the Open Market Option, which allows them to find an annuity provider that will pay them a higher amount.

However, there is another alternative: Pension Fund Withdrawal or Income Drawdown, which provides significantly more flexibility in terms of income, death benefits and investment potential, which, provided your fund is at least six figures, you should seriously consider.

Income Drawdown
Income Drawdown is a personal pension plan which accepts existing pension plan funds. It enables you to delay buying an annuity (an income for life). Instead you withdraw a regular income from your pension fund, within limits set by HM Revenue & Customs. Crucially you can vary the amount over time, as your needs change whilst the rest of your fund remains invested. Your future income is not guaranteed, but depends on the level of income drawdown, investment performance and future annuity rates. So there is the risk that you could end up with a lower pension than if you had chosen a conventional annuity straight away.

How does it work?
When you want to start taking your pension benefits you invest your retirement fund into an Income Drawdown Plan. You then take your tax-free cash sum from the Plan and leave the rest of your fund invested to provide your pension through income withdrawals or one-off withdrawals. The maximum level of income you can take over the first 5 years is based on the invested fund and HM Revenue & Customs rules. These are based on the calculations of the Government Actuary's Department (GAD). The maximum withdrawal is 120% of the GAD annuity and there is no minimum withdrawal amount.

Every 5 years thereafter the revised income limits are calculated based on your remaining invested fund and the HMRC's annuity rates at that time, until you reach age 75, when you need to buy an annuity or transfer to an Alternatively Secured Pension.

Phased Withdrawal
The phased element of withdrawal means that rather than taking the tax free cash up front, the annual income is made up of both the tax free cash and the taxable income. This provides significantly greater death benefits and can help to reduce the income tax payable.

Who could it be suitable for?
Income Drawdown can be taken out by people aged between 50 and 70 (from 2010 the lower age will be 55). It could be suitable for you if:

Your income needs vary from year to year. So if you think you might do some locum work in any one year after retirement, you’d have the option to reduce the pension income for a few months or years, thereby reducing your exposure to higher rate tax.
You want your pension fund to continue to benefit from potential growth and are prepared to accept the risk that its value may fall rather than rise.
You have other sources of income so you may not need such a high income from your Income Drawdown Plan in the early years of retirement.
You want to attempt to maximise the benefits your family receive on your death and give them maximum choice about how they receive these benefits.
You wanted to draw as much income as possible subject to ensuring an adequate income in the future, maintaining a level of control over your pension assets.
You have a requirement for a regular monthly income and do not have any initial need for the large tax free lump sum.
You are in good health – those in poor health may be better suited to an enhanced annuity.
A significant proportion of your expenditure is discretionary. For example, if you plan to spend a lot on holidays, this means that you could survive on a lower income if necessary.
You have retirement income from a variety of sources such as NHS pension income, income from state pensions, rental income from investment properties and other investments.

What are the drawbacks?
The main drawback of Income Drawdown compared to the conventional annuity route is the greater degree of risk. For example:

Your income is not guaranteed - it depends on the level of income drawdown, investment returns and future annuity rates. Your fund may not perform as well as you had expected and the benefits you get may end up lower than if you'd chosen the traditional annuity route.
The withdrawals you make to provide an income reduce your remaining fund and may erode the capital value of the remaining retirement fund below that originally invested, especially if investment returns are poor and a high level of income is being taken. This could result in a lower income when the annuity is eventually purchased or an amount less than you would have received under an existing arrangement.
Annuity rates vary over time. They may not improve and may worsen. If you leave it until the last moment to convert your fund into an annuity, you will have to accept the rates available at the time.
The charges you pay for Income Drawdown will be higher than for a conventional annuity.
Annuity rates are set knowing that some people will die before their average life expectancy and some will live beyond it. Annuities are set up on the basis that the unused funds of those who die earlier than expected are available to help to pay the annuities of those who live on. This process is likely to be available and this will be reflected in the annuity rates. To compensate for this, the investment needs to grow by an additional amount. This process is called mortality cross-subsidy. By delaying buying an annuity, you lose the mortality cross-subsidy generated by those who die before you buy an annuity.

Fund Choice
This is a fairly crucial part and care should be taken to maximise the investment potential whilst avoiding the above risks and ensuring that the investments chosen match your attitude to investment risk.

Typically there should be an element in cash if you plan to take the income immediately so the initial withdrawals can be taken from the cash fund. This is because withdrawing funds from more volatile investments can have a negatively disproportionate effect on the fund value at the start of the plan.

Once the cash fund has been reduced to nil it is then appropriate to take the income from either all or a mixture of the funds depending on their performance and fund values.

Choice of Pension Provider
There are various factors which you should use to compare the various providers that offer these types of plan. The key ones are financial strength, service levels, charging structures, large fund discounts, ability to automatically phase in money into equity markets (especially useful during these turbulent times), the internal SIPP bank interest rate, number of external investment funds, and whether the trustees are in house.

Annual Reviews
It is very important to have annual reviews to monitor the progress of the arrangement throughout retirement. Your Independent Financial Adviser will also:

Check that the growth of your fund is making up for the income you are taking from it,
Review the investment strategy of your pension fund and find out how much it needs to grow to keep paying you the income you want,
Decide where the income should be taken from,
Consider your state of health, as this may affect the decisions you make and whether you want to buy a lifetime annuity,
Consider your income requirements for the coming year,
Rebalance the portfolio to remain in line with your stated attitude to investment risk.

If you would like a free guide ‘Just the Facts About Your Retirement Options’ and ‘Just the Facts About Your Retirement Options - Income Withdrawal’, which explain the main features and risks attached to your pension options, please contact Essential Money on 0121 685 5060.