What is it?
Drawdown pension is a method of withdrawing benefits from your pension fund without purchasing a lifetime annuity.
Holders of money purchase pension plans can defer taking their pension in the form of an annuity and instead make withdrawals directly from the pension fund. This will first require the funds to be moved into a flexi-access drawdown plan or converted to flexi-access drawdown. [Any flexible drawdown plans that were in place before 6 April 2015 automatically became flexi-access drawdown plans on 6 April 2015 and capped drawdown plans in existence before 6 April 2015 can be converted to flexi-access drawdown.]
The main purposes of drawdown pension can be summarised as follows:
- Deferral of annuity purchase, thus avoiding being locked into low annuity rates which may apply at the time of retirement.
- The drawdown pension option enables the policy holder to buy an annuity at a time that is best suited to them and hopefully when annuity rates are more favourable or provides an opportunity to avoid purchasing an annuity altogether where appropriate.
- The option enables investors to retain control over their pension investments and allows them to continue to be invested in the markets.
- It postpones the decision of deciding which type of annuity to lock into, for example providing a contingent pension for a wife or husband and selecting a level or increasing pension.
- With flexi-access drawdown the amount of income that can be taken from the fund is not subject to any specific limits therefore this method offers great flexibility. This can be useful for tax planning or where other sources of income are available.
From 6 April 2011 rules were introduced such that anyone with a defined contribution (money purchase) pension arrangement (not final salary) who had not, before that date, taken a pension, could postpone the decision to take benefits from their scheme indefinitely (the previous requirement was that an income had to be secured by age 75 at the latest).
From 6 April 2015 the rules relating to defined contribution pension arrangements were relaxed further, meaning that from age 55 an individual is given unlimited access to their defined contribution pension funds and can withdraw as much or as little as they like. Any amounts withdrawn in excess of the tax free Pension Commencement Lump Sum are subject to tax. The rate(s) of tax payable will depend on the level of the individual’s total income including the amount withdrawn from the pension fund.
The critical yield calculation is an attempt to show the investment returns required from a drawdown pension arrangement to match the income that could be provided by a traditional annuity. The critical yield takes into account mortality drag and the additional costs involved in a drawdown pension plan. Crucially, it assumes that throughout the period of withdrawal the underlying annuity interest rate and mortality basis will not change.
The critical yield is an important consideration in deciding whether or not drawdown pension is an appropriate investment vehicle or not. Once established it is then necessary to decide how the funds will be invested to achieve the critical yield. Generally, if long term income is the requirement, the drawdown pension route will only prove to be more effective in total income terms if the investment return generated is sufficient to cover:
- The investment return on current annuity rates, plus
- Mortality drag, plus
- The additional costs involved in a drawdown pension arrangement as opposed to an annuity
Annuity providers know that not all annuitants will live as long as expected. The providers use this ‘mortality gain’ to subsidise current annuity rates. Therefore those clients who die earlier than expected subsidise the remaining annuitants. If you choose an alternative to annuity purchase, such as drawdown pension then you do not benefit from this cross subsidy and effectively take on the ‘mortality risk’ yourself. The longer you delay annuity purchase, the less you will benefit from the cross subsidy when you eventually buy an annuity. This is known as ‘mortality drag’.