What's wrong with income drawdown?

Elderly people on a benchIncome drawdown is one way to pay yourself an income from your pension pot when you retire.

Most people take an instead, which guarantees you an income, possibly rising each year, until you die.

In return for this solid guarantee, you give your savings pot to the annuity provider.

A healthy 65-year-old male who cashes in a pension pot of £100,000 for a non-rising annuity might today secure a private income of around £6,000 per year, if he shops around for it rather than buying it from his pension provider. If that's all he's got, state pension and other benefits should give him enough to live on.

About income drawdown

Income drawdown is an alternative that offers no guaranteed income. Instead, you keep some or all of your retirement pot and continue to invest it, while taking an income from it that can be anything from £0 up to around what you could get with an annuity.

If you have a guaranteed income of at least £20,000 from other sources then you're allowed to pay yourself a higher income from your pot, if you want to.

You can vary the income in the future, e.g. when you go from part-time to full-time retirement, but the higher your income, the more it will eat into your pot.

You can convert what's left of your drawdown pot into an annuity at a later date.

Why the regulator is worried

The Financial Services Authority believes that income drawdown is risky, as well as the financial advice related to it.

The FSA's guidance to financial advisers states that a high-risk investment strategy may be needed if retirees are to have a chance of sustaining income levels and preserving the pot over the long run, due to the fact that many people want to take a high income and because the (usually) high cost of drawdown schemes, including the cost of advice, makes it harder to be successful in this regard.

According to Money Marketing, the regulator has found sufficient evidence that some advisers aren't considering clients' needs, nor are they checking out whether they're emotionally suitable for these more risky products. The FSA also said other options are not always explored enough, and comparisons aren't properly documented.

A small FSA study, a review of 53 client files, revealed 34 cases where, due to lack of documentation, it was not clear if advice to use income drawdown was suitable.

So what's wrong with income drawdown?

Anyone drawing the full amount of income allowed can probably expect to see their pots shrink over time, and that's even if their investments perform quite steadily and reasonably. The worry is you'll then have too small a pot to sustain the required income.

The maximum amount of income you can draw down is linked to comparable annuity rates. However, rates are reviewed every three years (and every year after age 75). Hence, if your remaining pot has fallen in value, been eaten up too quickly in income, or if comparable annuity rates have fallen a lot since the last time, you might suddenly find your income drops.

This happened recently, when many people saw their incomes nearly halved due to a combination of falling stock markets and annuity rates.

Another risk for income drawdown

On top of that, changing government policy is one of the biggest risks for retirement savers and retirees, making it impossible to plan for the future with any certainty.

Many of those who chose income drawdown a few years ago are already cursing the government. Previously, they were allowed to pay themselves more from their funds than someone who bought an annuity, by an extra 20%. Suddenly, this extra amount was abolished, which hit some pensioners' incomes hard. (Others admittedly needed some more discipline imposed on them, since they were eating into their retirement pots too quickly.)

What is income drawdown for?

You need to think carefully before choosing income drawdown. Each retiree is different, and everyone, financial advisers included, has a different view on what income drawdown should be used for. Broadly speaking, I think you could choose it if you:

- Don't need much income from your pot for the foreseeable future, e.g. because you're still working part time.

- Want to take the allowed tax-free lump sum from the pot, but not start taking an income yet. (You can't do this if you go down the annuity route to begin with.)

- Would rather take what you can get now and pay 40% income tax on your income, instead of your heirs paying 55% tax when they inherit the pot.

Plus, you have to be absolutely ready to accept that you could end up much worse off later if things don't go very well.

One thing I never see government, commentators or professional advisers discussing is the way your benefits are affected by the amount of private income you're able to get from an annuity – even if you don't actually choose to get one. Read more in Saving in a pension? You're as well off on benefits.

Beware of forecasts

Another reason bandied around for taking income drawdown is the potential for swapping it for an annuity at a later date, when annuity rates have got higher again – since they have fallen particularly dramatically recently. This is understandable, but it is also a big gamble.

The stock market and annuity rates have fallen. This would normally indicate that you have a reasonable chance of doing better in future. There are no guarantees though. The stock market can fall again and annuity rates can remain low – and even sink further – for many years to come.

In the meantime, you're depleting your retirement pot by drawing down income, and your income is possibly falling every three years.

Remember, some financial advisers were recommending income drawdown before the stock market fell and annuity rates took another large tumble. So they're not forecasting gurus, and the best ones wouldn't claim to be. There are absolutely no guarantees about the future.

Check out our excellent to find out what income you could get if you bought an annuity now.