What is Income Drawdown ?
Instead of using the pension pot built up to buy an annuity, the money stays invested
and an income is taken directly out of the personal pension fund. The residual fund remains invested in a tax favoured environment.
From 6th April 2006 you no longer have to buy an annuity when reaching age 75 and
can continue in a form of Drawdown called Alternatively Secured Pension - however this may not be best for many people.
Your money will usually be invested in stocks and shares, property, bonds
and other investments while you take your income direct from your pension fund. You have to do this to try to get enough investment
growth both to pay your income now and to keep the value of your fund so you can afford to buy a decent annuity income later
on.
Critical Yields & Mortality Drag
A key figure to be aware of is the Critical Yield which is the annual investment return needed on your
remining fund, to ensure either that your chosen level of income can continue to be provided or that the final annuity you
can purchase will be adequate for your needs and to ensure funds don't run out.
The Critical Yield rises with age due to a factor called Mortality Drag.
Annuities are based on a cross subsidy - people who die before their normal life expectancy
(and therefore do not receive their expected payments back) subsidise those who live longer than expected (and therefore
receive more than expected). As you get older, and life expectancy reduces, the level of cross subsidy decreases. For
example -
- a 60 year old male will live, on average, to age 80 but could live from anywhere between 1 day to, say,
100. If he died after 1 day he loses out on 20 years payments which would then paid to someone else who lived to 100. The
average for both would still be 80 but the one who died early subsidised the one who died late for 20 years
- at age 90 the man will live, on average, to 94, but if he died earlier he would
only lose out on a maximum of 4 years benefits compared to 20 years above. The degree of cross subsidy therefore falls as
you get older and, because annuities price in this cross subsidy your investment return in Drawdown has to increase over time
to make up for this falling cross subsidy.
This article covers this important issue in more depth and the International Actuarial Assocation provide an informative Technical Note on Drawdown and Mortality.
What to think about
