Lower gilt yields drag down drawdowns

Investors are finding that they are unable to draw as much income from their pensions as they used to, because of falling yields on government bonds.

Yields on gilts have fallen sharply in recent months as market turmoil has forced investors to buy them as ‘safe haven’ holdings.

But this has had a knock-on effect on pensions – because, under the ‘income drawdown’ rules, the annual amount that an individual can take from a pension fund is calculated with reference to gilt yields. The higher the yield, the higher the pension income allowed by the Government Actuary’s Department (GAD).

This has already had an effect on people who want to buy an annuity. Pension investors have faced the dilemma of whether to delay buying an annuity to allow their pension pot time to recover, or to buy an annuity now before falling bond yields depress income levels any further.

But people who want to stay in income drawdown – a riskier way of taking pension income where the pension stays invested in the stock market and income is not guaranteed – are also affected.

Those in income drawdown schemes can take a maximum of 120 per cent of the given GAD rate for an annuity. So, last year, a 60-year-old man with a £100,000 fund could take a maximum of £7,800 a year in income drawdown. Now, that income has fallen to £7,080, according to Standard Life, as 15-year gilt yields have fallen from 4.75 per cent to 3.75 per cent.

But there may be ways for investors in drawdown schemes to increase their income.

John Lawson, head of pensions policy at Standard Life, suggests that investors use “dripfeed drawdown”. This involves splitting a pension into smaller parts and taking tax-free cash and income from a different portion each year.

So a person with £100,000 in a pension might decide to move £20,000 into drawdown in one year. From this, £5,000 could be taken as tax-free cash, and an income of £945 could be drawn from the remaining £15,000.

The hope would be that, as the years went by, a combination of the pensioner getting older and gilt yields getting better would improve that income.

But others warn that people in income drawdown should not be taking the maximum income in the first place. “The limits are there for a reason and, unless you have a very good investment manager, if you take the maximum income you will be stripping your fund down,” warns Tom McPhail at Hargreaves Lansdown.

Bob Fraser at Towry Law says that with maximum income drawdown limits set at about 7 per cent of a fund value, achieving the growth needed to replenish the fund at this rate – after charges – is unlikely. “If you take a higher income now, you could have a substantially lower income in the future,” he cautions.

Malcolm Cuthbert at Killik & Co reckons that since income drawdown was introduced in the mid 1990s, most people would have been better off buying an annuity, because of the risk of getting the investment choice wrong.

He says another way to boost income, for those still working, is to take income at the maximum limit, then put it back into the pension – a form of recycling. The amount paid back in receives tax relief at up to 40 per cent, and can be paid into a separate fund, from which a further 25 per cent tax-free cash can be withdrawn.