The drawbacks of drawdown
I have just received my income drawdown statement and it shows that my maximum income is going to drop significantly. How can this be?
Many people reaching their five-year reviews are in a similar situation. Three key factors influence the maximum withdrawal amount and all these are conspiring against you at the moment.
The first is the fund value of your pension. Given you have been withdrawing the maximum income for the past five years and stockmarkets have fallen during that period, it is no surprise that the value on which the next block of withdrawals will be based is a lot lower than that used in 2006.
For drawdown to be sustainable over the long term and to offer better value than an annuity, there must be a reasonable degree of investment risk. When markets are falling and high withdrawals have been maintained, capital values can fall rapidly.
The second factor is that of falling 15-year gilt yields. The GAD rate is used to work out what level of withdrawal can be taken, based on age and gilt yields. November 2011’s gilt yield is 3 per cent, giving a 65-year-old male a GAD rate of 5.9 per cent. If the yield had been 4.5 per cent, which is where it was five years ago, the GAD rate would now be 7 per cent.
This is compounded by the fact that prior to April 2011, the rules allowed you to with-draw up to 120 per cent of GAD. For reviews after April 6, 2011, it is 100 per cent of GAD.
If gilt yields and the 120 per cent figure had stayed the same, you would be looking at a maximum 8.4 per cent yearly withdrawal rather than the 5.9 per cent you are being quoted. This would still have meant an income reduction as the fund value has dropped but the fall would have been less.
It is important to remember these rules are to stop people from running out of money. The portfolio you are invested in may return 8.4 per cent or more in some years but, ultimately, that level of withdrawal is unlikely to be sustainable over the longer term. Even 5.9 per cent a year looks ambitious.
There are always exceptions but a rule of thumb would be that if you need to withdraw the maximum level simply to cover expenditure and you do not have much in the way of other assets to fall back on if things go against you, you probably should not be using drawdown in the first place. If markets go against you, it becomes difficult to recover.
At the other end of the spectrum, where the drawdown fund is only one of a number of sources making up the retirement income, the new flexible drawdown rules provide a way of maintaining the same level of withdrawals as before. To use this option, you must be able to prove you have £20,000 a year or more of guaranteed pension income in place.
Overall, the above chain of events is a stark reminder of the potential pitfalls of income drawdown. It is certainly not for the faint-hearted.
Jason Witcombe is director of Evolve Financial Planning