Income drawdown is regarded as the primary option in purchasing an annuity for retirement. It commences upon drawing variable income directly from the pension fund, which remains invested at the option of policy holder.
Basically, the member stays in control of the pension fund and this for many is what appeals to as income drawdown, but at the same time gives substantial risks. The policy holder usually decides where to invest and how much income to take within the prescribed limits.
Should they get it wrong and the value of the income and pension fund will fall resulting to a short of income later on retirement.
For the risk takers who opt to consider the income drawdown for a variety of reasons, below are among the most common scenarios along with possible investment strategies to ponder upon.
1. Taking tax-free cash along with negative income
Policy holders normally take up to 25 % tax-free cash from their existing pension fund and leave the rest invested in income drawdown. There is basically no requirement to take an income if its not required.
In this scenario, the investment strategy is more likely to depend on how and when they plan to begin drawing actual income. Should they be using income drawdown as a bridging tool until they are able to gain the entire fund as a lump sum upon the new and more flexible pension rules take effect by April of next year, it would be wise to stick to cash in general. The latter option safeguards the value of the fund.
On the other hand, should a policy holder does not intend to take an income until much later in their retirement, they probably need to be more insistent in their investment approach, keeping the fund invested in the stock market via investment funds or he/she can directly position the shares.
The retirement could very last 20-30 years, over which the timeframe shares have in the past out-performed other similar class assets such as government bonds or cash. However, there are basically no guarantees and any investment can fall in value as well as rise in order for policy holders get back less than what they previously invested.
2. Taking a regular paced income
Planning to take an income from the drawdown, then the existing investments need to keep up with the withdrawals, otherwise it will eventually run out of money later on in retirement. Should they take too much and investments won’t materialise the way they hoped it to be, the fund value and future income will eventually fall.
In this case, investing purely in cash will safeguard the value of the fund in the short term, but it’s highly unlikely that it will be an appropriate strategy as it is much less likely to produce the level of returns needed to sustain withdrawals.
One frequently used approach is to draw the income generated by the investments, but at the same time leaving the investments themselves intact with the optimistic expectations that it will hopefully grow. This is regarded as drawing the ‘natural yield’. If ever the market falls, they should still be receiving an income whilst they wait for the capital to recover.
Instead of investing in shares directly, which can be downright volatile, they may wish to gain exposure through a collection of equity income funds. This is geared towards investing in firms which have the possibility for increasing dividends over the long term, even as offering possible growth of capital. The fund manager spreads their money across a wide variety of dividend-paying companies which evenly spreads the risks.
To better diversify the income, they could opt to consider bond funds. Both government and corporate bonds have a good run over the past years and yields have diminished to prior low levels. Although the income they provide is within reasonable interest, they should consider the unexpected jump in interest rates or the rising inflation expectations that would nearly lead in prices falling should the income remain the same.
3. Seeking better ways to maximise income
For some investors, the natural yield does not offer enough income, hence some capital withdrawals are definitely necessary despite the inherent risks with the said approach when withdrawing capital as shown in their respective portfolio fall in value which later will result to further compounding losses.
There are steps that policy holders can opt to take in order to lessen the risk. The first is to ensure that their portfolio is solidly diversified and not purely dependent on the performance of the stock market. Funds that have the potential to perform in diverse market conditions should be carefully taken into account.
4. Taking a combination of dynamic and stable income
The essential point with income drawdown is the variability of income and not its security. Although in retirement, it can be very important to have some level of secure income to cover basic cost of living. Just as importantly, a secure lifetime income will last as long as one’s lifetime so that income will never run out.
Policy holders could consider using some of their pension to provide the needed guarantee of an annuity, which is primarily used to meet the essential expenditure along with income drawdown which offers a positive outlook of a growing income. However, it still carries considerable risks if not taken seriously. In broad strokes, this can provide them with the best of both options.