Dummy’s guide to income drawdown

Income drawdown is becoming an increasingly popular option for people entering retirement because it lets you take control of your pension savings and choose how they’re invested. Deciding how much income to take and where to invest your money is a complex task that requires a lot of careful planning.

What is income drawdown?

Income drawdown is a flexible way of taking money out of your pension to live on in retirement. Under Government rules you have to be age 55 or over to enter income drawdown.

Unlike an annuity – an insurance product that pays a fixed income for life – income drawdown lets you take as much income as you want when you need it. After taking up to 25% of your pension savings as a tax-free lump sum, you could use income drawdown to take regular monthly or annual payments or a series of ad-hoc lump sum payments.

Your pension pot stays invested when you’re in income drawdown and you have complete freedom over where to invest your money. If you invest in the stock market – either directly or via a fund – your pension pot could continue to increase in value, although that is not guaranteed.

Income drawdown exposes you to investment risk and there’s a real chance you could run out of money, but it gives you a lot more flexibility and control over your savings.

Getting started

It’s easy to move into drawdown if you have a Self-Invested Personal Pension (SIPP) with AJ Bell Youinvest. The benefit guide explains the risks involved in choosing drawdown and the next steps.

If you don’t already have a SIPP, it is worth noting that they offer access to a broad range of investment options: thousands of funds, shares, investment trusts and exchange-traded funds (ETFs).

Taking an income

Deciding how much income you need to draw from your pension is a difficult task because it’s usually impossible to predict how long you’ll live for. You should note that income drawdown payments are subject to tax so you may need to withdraw draw a higher gross amount from the pension to give you the net income amount (after tax) that you wish to receive.

Some financial advisers say taking between 4% and 5% of your savings every year will give you a good chance of making your savings last as long as you need them to, although this is not guaranteed. You should note that this approach involves selling chunks from your investments on a regular basis to generate income. Those lucky to live until a very old age therefore stand the risk of having their entire investments depleted before they die.

There are three main methods to approach income drawdown:

1. Take only the income generated by investments, known as natural yield. This is essentially living off any dividends paid by your investments.
2. Draw from your pension capital. Generate an income by slowly selling your investments.
3. Take no income and leave the pension to grow. This would only work for a period when you don’t need any more money to live after taking the tax-free cash element.

Natural yield

If you draw on the income generated by the investments themselves – known as the ‘natural yield’ – it leaves the underlying investments intact.

You can get income from dividends from shares, either held directly or via a fund. Please be aware that companies and funds don’t guarantee dividend payments as they can be reduced or cancelled at any time.

A popular choice for anyone seeking to collect dividends is an equity income fund. These typically hold shares in businesses that are expected to grow their dividends over time. As well as looking at a fund’s yield and return, it is wise to look at how much risk it is taking to get that return.

If you’re worried about your money running out you could use some of your savings to buy an annuity. This will give you some guaranteed income so that if you do end up living longer than expected you won’t have completely run out of cash.