Pension rule change means striking the right balance

A RULE change allowing pensioners to take more income from their funds came into force this week amid fears that it could leave some people destitute later in retirement.

The maximum amount of income that pension drawdown investors can take from their savings has gone up after the government eased restrictions imposed two years ago.

News of the increase, revealed in December’s Autumn Statement, came as a boost to many retirees who had seen their income slashed by up to half.

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There could be a sting in the tail, however, as by taking too much income some retirees could find their pension savings wiped out prematurely.

That fear that lay behind the original decision to reduce the income that pensioners can take from their investments.

The change applied to capped drawdown plans, where retirees can leave their pension invested and take an income from it throughout retirement or until they decide to lock into an annuity.

The advantage of drawdown is that it gives investment funds a chance to keep growing and provides extra flexibility. However, the pot­ential for losses makes it a risky strategy, particularly as there may be little time torecover lost ground.

That means drawdown is only suitable for those with substantial pension savings and alternative sources of income.

Many drawdown investors have suffered a sharp reduction in the income they get from their plans over the past two years, due to plunging gilt yields and the cut to the maximum income level.

That was set at 120 per cent of the value of the equivalent annuity – the GAD rate – before being slashed to 100 per cent two years ago, with the aim of protecting pensioners from seeing their funds dry up.

Now it has being restored to 120 per cent after it emerged that some pensioners had lost more than half their income largely as a result of the cut. The change took effect on 26 March, with the income limit for a 65-year-old rising from 5.8 to 7 per cent.

Steven Dunn, head of pensions at Anderson Strathern, said: “Since the reduction in the maximum rate only came into effect from April 2011, this does represent something of an embarrassing U-turn in government policy and is the result of considerable lobbying as many pensioners who had opted for drawdown experienced significant falls in their retirement income.”

The impact on investors varied with the timing of their drawdown review, carried out every three years and annually from age 75. Until April 2011 the reviews were every five years. That meant some investors who had their last review in summer 2007 were on review last year hit by income reductions of up to 55 per cent.

Dunn said: “The effect of the lower cap was compounded by the continued decline in gilt yields to which the GAD rate is linked, 
revised actuarial tables used by GAD to reflect increased life expectancy and stagnant investment returns for the remaining fund. Indeed, a reduction of 40 per cent or more was not unusual.”

Individuals won’t be able to take advantage of the increase until their next income year
begins, however. The income year is based on the date at which income was first drawn down from the pension, meaning some people face a 12-month wait.

But many will be advised to avoid taking the maximum income from their pension pot, particularly those with relatively modest savings.

As life expectancy lengthens the challenge of taking enough income without running out of cash in the years before death is becoming greater. Protecting pensioners was the aim of the reduced maximum income level, so its restoration comes with a risk.

Figures compiled by Liberty SIPP help illustrate how. A 65-year-old male with a pension fund of £187,500 would get annual income 12 per cent higher in the first decade of his retirement, under a 120 per cent GAD rate.

Between the ages of 75 and 84, however, his income would be 7 per cent lower than under a 100 per cent GAD rate, and 41 per cent lower between 85 and 95.

John Fox, managing director of Liberty SIPP, said: “The extra income people take now has to come from somewhere and that somewhere is the future income of the fund. For some, short-term gain could well result in long-term pain.”

So how much income should you take from your pension?

Tom McPhail, head of pensions at Hargreaves Lansdown, suggests taking the natural yield you would expect from your investments.

“This means an income of typically between 3.5 and 4.5 per cent a year – well below the new GAD maximum,” he said.

Another option is to take a higher income initially, said Dunn.

“There are good reasons why pensioners may want to take a higher income in the early years, particularly if this is a short-term measure to boost income while they wait for payment of an occupational pension scheme or their state pension to commence,” he explained.

It’s a delicate balance, however, and a decision best made with expert financial advice. Not only is it vital to make sure drawdown is suitable for you in the first place, you also need the right investment strategy in place.

If you’re taking your maximum income already and expect to take advantage of the raised limits, now would be a good time to take a fresh look at your investment strategy, said John Mortimer, director of Shepherd and Wedderburn Financial.

“The investment proposition underlying the pension drawdown should support the increased income,” he pointed out.

“If not, we are back at square one where the next pension review results in a large drop in income, not because of the GAD rates but as a result of the pension fund being eroded over the previous three years.”