Income drawdown plans, or unsecured pensions as they are now known, have been popular in recent years as rates on annuities have fallen, hitting retirement incomes.

At retirement, investors can use their pension pot to generate an income. Traditionally this has been achieved with annuities. In return for the payment of a lump sum, an annuity provides an income for the remainder of your life. The main downsides with these plans are that rates have fallen in recent years and that, on death, your capital is lost, leaving nothing for heirs.

Unsecured pensions allow investors to draw an income directly from their pension while maintaining investment control. On death, there is some money for your spouse or dependants.

That sounds attractive. Are they a good idea?

They can be. There are three main advantages of these schemes.

First, you – or a nominated adviser or investment manager – can control how your money is invested. If you are confident in your investment skills, this could mean you generate a rising income in retirement, although of course in the event of poor performance, your fund size and therefore your income could be hit. (Because of these risks, you may still want to buy an annuity with some of your pension money to give you a reliable income stream).

Second, you can vary how much income you withdraw. Under the rules, these withdrawal limits have been set at between zero and 120 per cent of a benchmark annuity income as determined by the Government Actuary’s Department. So if you have no need for income in any one year, you can let this roll up inside your pension plan. And if you take out the maximum, this is likely to generate an income slightly higher than you could have achieved by purchasing an annuity. The income limits you can withdraw annually are reviewed every five years. So, if at your five-yearly review, your fund has fallen in value, your maximum income withdrawal limits may also have fallen. The biggest risk is that if you take too many risks with your investments and performance is very poor, your unsecured pension could take a serious hit.

Finally there are the attractions of passing on some of your pension wealth on death. When you die, funds in an unsecured pension can be passed on as a lump sum to heirs less a tax charge of 35 per cent. Surviving dependants, provided they are aged between 50 and 75, can continue to manage the plan as an unsecured pension. Alternatively they can use the funds to buy an annuity, giving them a secure income stream. If the surviving dependant is under 50, the fund – less the tax charge – will convert to a personal pension.

Who can take out these plans?

You have to be aged between 50 and 75. By the time you reach age 75 you have two choices. Either you can go into an Alternatively Secured Pension, the equivalent of income drawdown for the over-75s or you can purchase an annuity.

ASPs have become less attractive since the pre-Budget report as the government has proposed a tax charge of up to 70 per cent on your fund on death. You can still pass on the entire fund free of tax to your spouse or dependant but when they die a tax charge of up to 70 per cent will apply.

Are there any disadvantages with income drawdown?

Yes. See the investment risks as highlighted above.

There are also the costs. Charges on unsecured pensions vary but you should expect to pay a set-up fee of, say, around £150, an annual administration charge of a further £150 or so as well as annual charges for investing in funds and an annual charge for remunerating your adviser. Depending on the size of your plan, total annual charges are likely to be 1 to 2 per cent, which will act as a drag on performance.

You should also factor in “mortality drag”. If you had bought an annuity – because these pool thousands of individuals together – for each year that you survive you effectively benefit from an income uplift from the redistributed capital of those who died early. This is called the “mortality cross-subsidy”. For younger retirees, aged under 60, the effects of this cross-subsidy are not significant. But as you approach 75, they start to escalate.

If you are in an unsecured pension the loss of this mortality cross-subsidy is called mortality drag. At age 60, mortality drag equates to around 1 per cent. Therefore in order to match the income you would have received from an annuity, you need to beat your benchmark annual performance by 1 per cent a year. But by age 75, this can reach 4 per cent a year.

So are they a bad idea then?

No. It depends on your circumstances and your attitude to risk. With an annuity, if you live a long time you are a beneficiary of the mortality cross-subsidy, giving you a good deal. However, if you die early you lose out.

With an unsecured pension, if you live a long time, you may find it hard to match the income you would have received from an annuity. But at least if you die before age 75, you can rest assured that your remaining fund will be passed on to heirs.

To gauge whether your unsecured pension is matching what you would have received from an annuity, you should set yourself an annual performance target. This should be the yield on UK government bonds (these are used to back annuities), currently around 4.5 per cent, mortality drag and annual plan charges. For a 60-year-old, assuming annual charges of 1.5 per cent, this would equate to an annual performance hurdle of around 7 per cent.