Put very simply a Drawdown plan is like using your pension pot as a bank account and you are drawing down money from it every month. How much you can take is determined by GAD rates (see below).
How does Income Drawdown work?
You will always be entitled to 25% tax free cash of your pension pot but you may not always need the full amount on day 1.
An income drawdown plan allows you to determine how much tax free cash you want and how much income you want, both within limits.
So if you had £200,000 you would be entitled to 25% or £50,000 tax free cash, then you would use the rest to buy an income, this has been the usual way of taking a pension. In this instance you may want to take say £10,000 tax free cash and then nil income. Its important to remember that you do not lose the other £40,000 tax free cash you are just deferring when you take it, so you may take it in 5 yrs time. The point is that an income drawdown allows you to be very flexible with how you take income and tax free cash.
The levels of income are determined by GAD rates or Government Actuary Department rates, this is a calculation based on your age, amount in your fund, gilt rates and then this shows you how much you can take from your fund. This is designed to make sure that you do not run your fund down to zero.
Risk – When you are in income drawdown your money is invested, you can look at this in a number of ways remember you have been invested all your life whilst you have been saving for your pension so you have experienced risk. Also the traditional convention is to go for an annuity as this is guaranteed income a drawdown is not guaranteed, so the risk is there. It must also be stated that whilst you are taking money out of your pension plan then you are exposing yourself to more risk because if your fund goes down its harder to make money up whilst you are taking an income.
Drawdown is complicated – When you compare a drawdown to an annuity yes its not as simple as an annuity, an annuity pays you the same every month for the rest of your life. A drawdown can work around peoples complex lives, nobody is the same and a drawdown plan is there to help when life changes through retirement, whether that be a need for lump sums at different stages in life, a change in income whilst some part time work is being done. The complexity of it leads to the need for;
Financial Advice – Always take financial advice when setting up a drawdown plan, its a very specialist product and always finda financial adviser with experience in these products. Getting it wrong can becostly there are a few do it yourself drawdown providers out there but when you analyse the costs you will often find that the costs are more than getting advice and you do not have the safety net of the Financial Services Compensation Scheme, so why take such a risk.
Reviews – A drawdown plan has normal review levels of every 3 yrs if you are below age 75, after age 75 this review is every year. At this review you will as a minimum have your income reviewed. So if you were taking maximum income and your fund went down significantly then you could be asked to reduce your income levels, depending on GAD rates at the time. If you have taken advice you will get a review every year at least and this will be very comprehensive going through investments, any changes in circumstances etc.
Death benefits – One of the big things about a pension drawdown plan is the fact that should you die then the fund does not go to the insurance company, the fund is available in the first instance to keep going to your wife/husband and then it can pass on to your estate as a lump sum. This lump sum is taxed at 55% though.
Costs – Traditionally it has been suggested that Drawdown is a costly option but this should not be the case if you really compare the costs to an annuity. Of course this is very hard to do as we do not know the exact costs of an annuity because what you get is what you get until the day you die so the longer you live for the cheaper an annuity is. A drawdown plan comes with annual management costs which pays for reviews.
Compare Drawdown providers – Have a look at this link here, this will give you a good comparison to some of the drawdown providers out there to make sure you are going for the best deal.
- Flexibility. You can turn income on and off as and when required.
- Death benefit – Should you die then the pension will pass to your
spouse and they could continue to draw it as you were doing, or they could take it as a lump sum minus 55% tax.
- Investment – You can still invest in the markets if you would like to do so; this can be based on your attitude to risk.
- You can structure your income to be very tax efficient; for example you may not need all your tax free income in one lump sum, and could therefore take it on a flexible basis, meaning that a proportion of the income in year one could be tax free, thereby reducing your tax liability.
- Increased income – Should your investments do well then you could find that your income rises.
- Invested – When you reach retirement you may not want to expose yourself to any risk, and this could mean that your money runs out.
- Decrease of income – As your money is invested, your income could decrease should the investment decrease in value.
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