Thousands of pensioners face 50% drop in income

THOUSANDS of people invested in drawdown plans are facing a major pensions deadline which will cut their income in half. Their drawdown arrangements must end once they hit 75, and they could find themselves forced to crystallise their retirement funds when markets are at historic lows.

Scotland on Sunday examines their options and answers their questions.

Was drawdown a bad idea?

Not necessarily. It is simply timing and the markets that are causing headaches. Up to 20,000 investors across the UK are believed to have decided against fixing their income at retirement for the rest of their lives by buying an annuity, but opted instead to invest the cash in a drawdown scheme paying a regular income.

What was the attraction?

Firstly, the hope was that with good investment performance the fund would grow and, secondly, they could cash in on annuity rates which are far more generous at 75 than at 65. There can be tax advantages too. If they die, their pension could be left to their children, subject to a 35% tax charge.

Finally, it is possible to withdraw more each year from a drawdown scheme than you could via an annuity, which allowed money to be released more easily; another useful way of passing assets to the next generation.

What's the problem?

Once the plan holder reaches 75, the fund must either be used to buy an annuity or transferred into a different, and slightly less attractive, drawdown arrangement called an Alternatively Secured Pension (ASP).

However, most people's funds would have slumped by between 20% and a third over the past year.

Stuart Bayliss, of Annuity Direct, said: "It's hell out there if you are trying to make any kind of long-term investment decision. Undoubtedly your fund has been hammered and you're desperate for security."

Hargreaves Lansdown's Tom McPhail added: "We're surrounded by uncertainty, and investors are caught on the horns of a dilemma. Yes, markets should recover and annuity rates may stop falling, but there are no guarantees."

Are there any alternatives to buying an annuity?

There are, but all of them will see the income most drawdown holders live on halve.

Take someone who retired 10 years ago with a 500,000 pension pot which he placed in a drawdown arrangement. If he invested it in a pension fund with above-average performance, and took maximum income each year, he should this year have 44,000 to live off. But this income would have been calculated using last year's valuation when the fund stood at nearly 385,000. Since then it will, at best, have fallen by more than 20% and be valued at 260,000.

So the worst thing he can do is buy an annuity?

Not necessarily. It will depend on his individual circumstances. Annuity rates too are falling, although not so sharply at 75, but this is from a relative high. At 75 an annuity will still pay a return of more than 9%.

Gordon Forbes of Caledonian Asset Management said: "I'm telling some clients to go ahead and buy the annuity with at least some of the money. We are now getting much better returns on the annuity contracts themselves than 18 months ago.

"Yes, their funds are down, but it is a case of balancing up all the facts.

"Where people have big enough funds, I recommend at least consider annuitising half."

McPhail agreed: "If you think you will want to buy an annuity over the next year, then go on and do it. The rates will continue to fall in the short term."

If the investor decides to fix his income now, a 260,000 lump sum could secure him a pension of around 24,600 for life, or 21,844 for a joint annuity to cover a spouse. With inflation-proofing that income falls to 18,426 for a single male, or 15,758 for a joint life.

However, if inflation were to pick up in the years ahead, as some commentators predict, interest rates might rise again, taking annuity rates with them. Investors may then regret having bought at what with hindsight proves to be a low point.

Can you buy an annuity and still share in a market recovery?

Only if you are prepared to take on some risk. One way to hedge your bets is to opt for an investment-linked annuity. Companies such as the Prudential, Legal & General, Liverpool Victoria and Norwich Union offer a with-profit annuity, and Scottish Widows has a unit-linked one.

These invest your pension fund in with-profit or unit-linked funds. You are allowed to take income, although this would normally be at a lower rate than a conventional annuity, to allow for market setbacks. If investments improve over the next few years, then so too could your income.

However, if markets deteriorate then your income could fall, or worse, the money could run out altogether. Companies often introduce exit penalties at times of turbulence, which can make these inflexible.

How does an ASP work?

If you want to ride out the storm then it could make sense to transfer into an Alternatively Secured Pension until markets improve.

Bayliss said: "If you're worried about locking into an annuity right now, then don't. Give yourself a couple more years. But make sure you have a strategy. Set yourself a goal of where you will be happy to annuitise, and when the markets reach that level, sell out."

The income you can take from an ASP will be smaller than with drawdown because these plans operate under different rules.

The death benefits also deteriorate. Under both, the pension fund can be passed, tax-free, to provide a pension for a spouse. However, whereas with drawdown the fund can be inherited by children subject to a 35% charge, in an ASP nest eggs are hit by an 82% tax charge if handed to the next generation.

Also watch out that you are not charged additional fees for switching into an ASP.

Can you take a higher income after 75?

If emptying the fund is your priority, perhaps because you want to pass cash on to your children, then some flexible investment-linked annuities, such as one run by Lincoln, will allow you to continue withdrawing 120% of a conventional annuity as income, even after 75.

However, you are obliged to buy an annuity once the fund falls to roughly a third of its value, and charges may be higher.