What is Income Withdrawal / Income Drawdown and how does it work ?

Technically, the correct term is Income Withdrawal but this product is known more commonly as Income Drawdown. Income Withdrawal was originally introduced as part of the Pensions Act 1995 so has been around for more than 10 years now.

Think of Drawdown as being like a building society account. Under either a personal Pension or an occupational pension you have built up a fund of say £100,000.00. Instead of using this fund to buy an annuity you put the £100k in the building society, which attracts interest. You then take out of your account an amount each month to live on, say £500.00. Then at the end of the year you will have taken out £6,000.00 in cash and with interest on the account your £100k may now be worth £98,000 but you will have taken the £6,000.00 out over the year.

Alternatively though you could invest your £100k in UK equities instead of a building society, in which case, on the same scenario your fund at the end of the year may well be £110,000.00. This is where risk comes in. If you had gone into Drawdown in January 2000 and put your whole fund in UK equities by March 2003 it would have halved in value !

Very simply, this is how Income Withdrawal works.

For further detailed information Click Here.

Who might want Income Withdrawal / Income Drawdown ?

There are probably three categories of people who should consider Income Drawdown:

1. Other sources of income

This is where you have a pension fund mature, you do not particularly want to buy an annuity and you have a comfortable level of income already. In this scenario you may consider that taking some risk with your pension fund monies is worth taking. Generally, over the longer term (20 plus years) any reasonable equity based investment or managed fund should achieve a return of 10.25% to 12%. But consider that in on the 4 January 2000 the FTSE 100 reached 6,930.2. By 13 March 2003 it had fallen to 3287 ! This was a 52.57% fall.

Therefore:

If you had gone into Income Drawdown and 100% in UK Equities on 4 January 2000 then, over a 6 and a half year period, your fund would still be nearly 15% less than its starting value. However, if you had done the same on 13 March 2003, in a little over 3 years your fund would have gone up by nearly 80%. What a difference three years can make. This exaggerates the risks involved and why perhaps, if your pension fund is your only source of income then Income Drawdown may not be for you. However, it is, at the end of the day, YOUR pension fund.

2. You want to take your lump sum from your pension fund but do not want to take an annuity.

There are many reasons why you may want to take your Tax Free Cash and not take an income or annuity and the only way you can do this is through Income Drawdown.

I would make a comment here. The new pension's legislation which came out in April this year renamed Tax Free Cash to 'Pension Commencement Lump Sum' !! The reason for this is not subtle, it is so that, at some point in the future they can remove the Tax Free status of the lump sum ! As if pensions have not been plundered enough by BOTH governments !

3. You are in poor health and you wish your spouse, partner, children or cats home to benefit from your pension fund.

If you are in poor health and you need to take an income then Drawdown is a real alternative to buying an annuity.
This may be your scenario:

You need to take an income from your pension but you have been diagnosed with a terminal illness and may have a short life expectancy of just a few years. You have a fund of £100k. You put your £100k into drawdown and take £600 per month. Your fund does well and in 5 years time you pass away and your fund is now worth £140k. This £140k can either be used to buy an annuity for your spouse, or they can continue to take drawdown or can have a lump sum ( subject to tax ) or the fund can go into your children's pension accounts ( again subject to tax ) or can indeed be paid to Battersea Dogs Home.

Useful Links:

Government Actuaries Department site on Income Withdrawal
www.gad.gov.uk/Pensions/Income_drawdown.htm

Instructions from HMRC on how to use the GAD tables for Income Withdrawal
www.hmrc.gov.uk/pensionschemes/gad-tables-instructions.pdf (Adobe PDF)

Actual GAD tables
www.hmrc.gov.uk/pensionschemes/drawdown-tables.xls (Excel Spreadsheet)

Since April 2006, the maximum you can take from Income Drawdown/Withdrawal is 120% of the Basis Amount calculated using the GAD tables see this link:
www.hmrc.gov.uk/manuals/rpsmmanual/rpsm09102310.htm

FSA Fact sheet on Income Withdrawal
www.fsa.gov.uk/pubs/public/income_withdrawal.pdf (Adobe PDF)

FSA Q&A on Income Withdrawal
www.fsa.gov.uk/pages/Doing/small_firms/advisers/FAQ/withdrawal.shtml