In his second guest blog of the week, Andy Leggett of Barnett Waddingham looks at the imminent changes to Income Drawdown and highlights the risk of immediately increasing your income:
Income Drawdown is a fantastic product for some. One of its central features – being able to vary the level of income you take from your SIPP (Self-Invested Personal Pension) – gives fantastic flexibility. We all like flexibility: it gives us more options and a sense of freedom. More prosaically, it can save us tax.
Lots of people may benefit from this flexibility – it fits well with more modern, less rigid notions of retirement. Many wind down in stages into retirement instead of suddenly stopping work and may want to replace their diminished earnings in stages. Those that are self-employed may always have had variable earnings and can now smooth them out as they gradually enter retirement. The principle also applies for those depending in part on variable investment income or from rent as private landlords, for example. Taking income only if you need it – and only up to the extent to which you need it – keeps as much money as possible within the tax efficient pension wrapper and exposes as little income as possible to tax.
As we know from the personal finance pages of the national press, however, increasing numbers of pensioners in Income Drawdown have found themselves bumping up against the maximum income limit – unless you are in Flexible Drawdown, there is only so much income you can withdraw from your fund in a year. The flexibility of drawdown was curtailed back in April 2011. I don’t want to get all technical about how the maximum level of income you can take from drawdown is calculated but basically there is a formula and part of it was cut from 120% to 100%. From the start of your first pension year, after the 26th March 2013, that will go back up to 120% – an example of why pension people grumble about politicians, just like normal people do.
This means greater flexibility, which intuitively seems like a good thing. The truth is a bit more complicated than that. For with greater flexibility comes greater responsibility, as Stan Lee (and others before him) might have said. The more you take out of your fund, the more you demand from your investments and the greater the risk you won’t achieve it. The extra 20% income you will soon be able to take isn’t free: it is a considerable extra demand on the fund.
Expressing this in other ways to drive home this important point, the more income you take from your fund, the more you diminish your capital; the more income you take from your fund, the greater the level of capital growth or investment income (or both) you will need; the more income you take from your fund, the more risk you are likely to seek; and finally, the more income you take from your fund, the more vulnerable you are to sequence risk.
Sequence risk is a particular danger for drawdown and anyone contemplating drawdown should know what it is. Here’s a crude explanation for the uninitiated. Markets go up and down, we know. However, because you are taking income from your fund, for a given set of ups and downs, the sequence with which they occur affects the fund value at the end. Early losses can mean that later gains are insufficient for your depleted fund to recover.
There are, of course, all sorts of good practices you can apply to try to reduce investment risks. Diversification across markets, asset types, economies, sectors, currencies and so on avoids having all your eggs in one basket. However, you must not allow these to create a false sense of security: you may reduce certain risks but you will not eliminate them. Good practice is not the same as a law of physics.
If investing is in any sense a science, arguably it is a behavioural science for we are all predisposed to our innate human biases. Again, before investing, you would do well to acquaint yourself with concepts such as loss aversion, the endowment effect and more. Such things will be secretly trying to guide your decision-making as you undertake the essential task of monitoring of your portfolio, the risks you face and how things are going versus your expectations.
So before you reach to restore your drawdown income to the 120% maximum, may I suggest that you ask yourself where the extra income is coming from and how you are managing the extra risks? Furthermore, since mistakes later in life are so much harder to retrieve, you might like to consider taking regular financial advice.
Andy Leggett, Head of Business Development, SIPPs at Barnett Waddingham SIPP can be contacted on 0844 443 0100 or by emailing email@example.com
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