Pensioners in drawdown will be able to take an increased income from 26 March 2013.
The Government surprised many in the Autumn Statement, the maximum drawdown limit on income that can be taken in capped drawdown was increased from 100% back to the 120% level. However, investors currently in a drawdown year will remain on the 100% GAD rate until their new drawdown year starts.
Drawdown allows retirees to keep their pension fund invested and take an income from it each year. The amount of income that can be taken from an income drawdown policy is based on calculations made by the Government Actuary’s Department (GAD), known as GAD rates.
These GAD rates are linked to the annuity rates offered by insurance companies, which have fallen dramatically. This meant that drawdown income falls and so the government decided to decrease the amount of income that could be taken from 120% of the GAD rate to 100%.
The last few years have been difficult for many drawdown clients and some may be tempted to simply push income back up to the maximum 120% as soon as allowed.
However, it is important to tread with caution. Taking maximum income each year runs an increased risk of quickly eroding capital. Investors must consider, if this is the case their ‘capacity for loss’. This is so clients can cope with any nasty surprises.
Drawdown members are facing unprecedented times, with many seeing their income drop by over 40%. The reduction in the maximum allowable income was not the only reason behind this drastic fall. Pushing income back up to 120% of GAD rates would only cut the income drop to a ‘mere’ 20% or so.
The cause was a combination of many factors –
Low gilt yields played a part, as did the high income levels some people were stripping out of their drawdown pots. Taking 120% each and every year means people need high investment returns to maintain that income. This is where the client’s capacity for loss becomes crucial.
A client’s capacity for loss (their ability to absorb falls in the value of their investment and associated pension income, is a key focus. This needs to be considered separately from attitude to investments and their associated potential risks.
There are two things to consider. One is around the type of investment needed to try to achieve a higher yearly return and how this fits with a client’s attitude to investment risk; and their capacity for potential losses.
Investment performance, risk and volatility suitability and portfolio stress testing must be reviewed (in my opinion) on a regular basis, taking into account changes in the customer’s health and personal life, as well as what has happened to their pension and other investments. In that way clients are more likely to understand, and be able to deal with, any drops in income and the portfolio can be managed and adjusted as required.
I believe income drawdown is undoubtedly a good contract which can be hugely beneficial for some clients.
Recent history has shown that drawing 120% income comes with repercussions – higher investment returns are needed to maintain that income, and, for most clients, investments have simply not achieved these high hurdle rates over the last five years.
Relying on critical yields to work out whether investment returns are acceptable is unlikely to be a good strategy. Instead, using some form of cash flow modelling along with regular scrutiny of whether a lifetime annuity or investment linked annuity may be more suitable, could pay dividends for both adviser and client.
A possible strategy is to take an income no more than the natural yield generated from the underlying investments is the optimum way to protect a drawdown fund over time.
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