Accessing Your Pension: Annuity Vs Income Drawdown

Transcript
Holly Cook: All this week on Morningstar.co.uk we've been telling you about how you can build that income portion of your portfolio. We're now going to talk about the options available to you when you actually want to draw down on that income. I'm joined by Gianni Campopiano, he is the Principal of Foundation Financial Planning.

Gianni, thanks very much for joining me. (from Foundation Financial Planning)

Gianni Campopiano: You're welcome.

Cook: Now I know this is a complex area and we can't possibly cover it all in one video, but we want to talk about some of the key issues that investors need to know about. So, let's start with annuities. What are some of the main pros of annuities?

Campopiano: Well, they're easy to understand and they are outside your estate for the purposes of inheritance tax. They are relatively inexpensive to set up. They are — when your income is agreed at the outset that income cannot fall; it can rise and it cannot be taken away. Annuities have provided a reliable source of income since records began. They are ideal for someone who is lower risk, who wants lower admin, who wants nil ongoing charges, who doesn't need to plan for tax and is comfortable with waving goodbye to their pension capital. They also benefit from something called mortality gain, which is where annuitants die early and help to subsidise those that live longer.

Cook: Okay, and I'm sure there is a flipside to this, what are some of the cons of annuities?

Campopiano: Well, the cons are is that the income cannot be switched off…and cannot be varied. They are not good in inflationary environments. You're saying goodbye to the capital forever. You cannot benefit from rising markets, and essentially you are agreeing to something as a one-off that can't be changed forever, forever after.

Cook: So potentially it might be seen as a sort of safe option if you don't want to take on any risk, any market risk, but you're really tied in…it's a done deal?

Campopiano: Absolutely right. You're quite right. You don't take on any market risk because your income will remain the same, whether markets go up, down or sideways.

Cook: Okay, so how about the other option: income drawdown was introduced in 1995, what are the pros of that?

Campopiano: Income drawdown: income is flexible, so within limits can be varied…it can drop down to zero but once again, within limits, is variable. When mixed with ‘phased drawdown’, there are benefits to income tax, inheritance tax and estate planning. You can always buy an annuity later on when you're more sure of your circumstances. Once again, when linked with phased drawdown, your PCLS—your Pension Commencement Lump Sum, more commonly known as ‘tax-free cash’—can increase, but that's if markets rise and if your adviser’s on the ball. They also, I think the death benefits are very important and also you can benefit if the market rises, you can do quite well. Ideal for someone who wants to plan for tax, who is uncomfortable with saying goodbye to their pension capital, and for someone that probably has a bit more capital available and therefore might be willing or able to undertake a little bit more investment risk because your investment is subject to market ups and downs, whereas annuities are not.

Cook: So I'm sure you're going to tell me then that if you are subject to market ups and downs, it can increase in value, but it can also decrease in value. What are the cons?

Campopiano: Yeah, the cons are as you say, the income is very subject to market conditions. The income can also go down because of Gilt yields; there has been a huge reduction in gilt yields, which has affected people's income. If you then add that to possibly shrinking fund size, you can have problems. But I just need to balance that by saying if the fund is managed well then your income can increase or at least stay the same. So, there are cons, but there are advantages and you just need to make sure that the advantages meet your circumstances more so than the disadvantages.

Cook: And you mentioned earlier, with annuities, the mortality gain, whereby those with annuities can actually benefit from those who die and leave money behind. What happens with the income drawdown?

Campopiano: Yeah, a good question. Mortality drag is the opposite of mortality gain, and so someone in drawdown—flexible drawdown or uncapped drawdown—will not benefit from other annuitants dying. It's purely based on their own fund. Important to mention that if you've got qualifying income of £20,000, you can draw the entire capital down from a flexible drawdown account. So, that's quite a valuable circumstance. And if someone is in particularly ill health, say, then you are best not going into either drawdown or annuitisation, you are best not vesting at all.

Cook: Because then you've actually got that capital available for whatever you may need it for?

Campopiano: Exactly. Well, that will pass through your estate, and if it's set up correctly it's going to pass through your estate without the application of inheritance tax. So, once again, benefits to that [drawdown] approach rather than annuities.

Cook: And you mentioned also capped and flexible drawdown, can you explain what the difference is?

Campopiano: Yeah, capped drawdown is where you don't have [annual] income that exceeds £20,000—that's qualifying income that exceeds £20,000—so flexible drawdown is not available to you. If you have income that exceeds £20,000, then flexible drawdown is available to you, and what the rules say now is that you can draw all of that capital down. There is tax consequences, which you need to address, but a very valuable benefit, if that suits your circumstances. You are taking that money out of a very tax-preferentially-treated environment, but once again just take some in-depth advice about that to see if it's right.

Cook: So when it comes to – if you've gone for the income drawdown option, whether flexible or capped, what sort of factors decide the rate at which you draw down your income?

Campopiano: You've got gilt yields, very important factor, in '95, gilt yields were about 8%; in February of this year, they were 2.5%. That's a 72% reduction. That's really hit people hard. So, that's a factor. The other factor is how much you can afford to drawdown without the capital diminishing. So, just look out for that.

Cook: And health presumably as well, that's going to be one main factors that you…

Campopiano: Health is really important, health is vital. [It’s vital] that the adviser understands at the outset how your health is, and also how your health continues going forward into the arrangement.

Cook: It's just something that's extremely hard to plan for; you don't know what's going to happen…

Campopiano: Yeah, it's part of the review process: “How is your health?”, and then you need to ask that question when you're reviewing.

Cook: So in your role as a financial adviser, what's your toolkit made up of when you're trying to find this income for your clients?

Campopiano: Yeah. Okay. High yielding defensive funds, there are numerous ones, some are good, and some are not so good. At Morningstar – the facilities that we have with Morningstar obviously help us to find out where the good ones are, and in other areas too. And there are exchange traded funds, income yielding exchange traded funds; good quality corporate bond funds; and also directly held corporate bonds, which you can get through the London Stock Exchange on the order book; and also directly held corporate bonds that are newly launched; and property funds, income yielding property funds; and yeah, that's about it. But you're really trying to tailor an income profile for an individual that needs the income requirements.

Cook: So you've got all the tools and you adjust that depending on their needs?

Campopiano: Yeah, their circumstances, how their income is being affected by the three yearly reviews, taking a lot of different things into accounts, in order to calculate a set of circumstances that meets their needs.

Cook: It sounds like there's a lot of different options here and there's a lot of flexibility and there's also a lot of moving parts. I mean, this really is an area where somebody could really benefit from financial advice to help them decipher their way through this, what could potentially be a minefield?

Campopiano: It is a minefield. So there needs to be a process that an adviser follows that takes into account the circumstances of the individual. At the finish, an adviser needs to be adding value, so—and he or she needs to communicate that value—so the client can understand. But my experience is such that all clients that have gone through that process, have been happy to pay the fees because the process has delivered a great deal of value.

Cook: And even if, let's say, the markets are so bad that you can't potentially add that value, it's better to at least know whether you are on track to meet your goals and to have that expectation of whether you need to adjust your idea of what your retirement is going to be like. Better to hear the bad news than to have no idea?

Campopiano: Absolutely right, because if you're drawing income at a rate that is inconsistent with your set of circumstances then you just need to know that. If you should have an annuity, then someone needs to communicate that to you, and go about sourcing an annuity that meets your needs. So, the whole thing is really worthwhile, and I clearly believe in it. I can understand why there are clients out there that perhaps are a little bit sceptical, but a lot of advisers offer a free initial consultation and it's certainly worth going to look for.

Cook: Well, thanks very much. You've given us a great overview of some of the options here.

Campopiano: You're welcome.

Cook: Thanks for joining me. From Morningstar, I'm Holly Cook. You can find related links to more information about income drawdown and annuities below this video. Thanks for watching.