Setting Realistic Incomes

Following the changes to pension plans from the Budget in March, anyone over the age of 55, from April 2015 will have full flexibility in what income they take from their pensions. No doubt there will be many that decide to encash their plans fully, take that holiday of a lifetime, buy a new, update the house etc, but what happens after the money runs out?

We feel this new flexibility will in fact complicate, not simplify pensions. Firstly, any 'drawdown' in excess of the maximum 25% tax free amount will be subject to that person's marginal tax rate as if it were any other form of income. Therefore, planning the rate that income is drawn may depend on careful tax planning.

Next, the amount of income that is drawn will also be influenced by the underlying investments and what income level they can sustain. When the concept of pension 'drawdown' really took off, this was referred to as the 'critical yield'.

In theory, the investment return needs to cover all the charges of the plan, including fund management, advice fee and platform charge perhaps, as well as the current rate of inflation and any growth to cover that year's income. For example, if the ongoing charges amount to 1.50% and inflation is 2.50%, the investment return would need to be at least 4.00% just to preserve the real value of the investment. A pension portfolio of £100,000 supporting an income of £4,000 per annum would therefore need to gain at least 8.00% per annum.

If the income need is based on 'net of tax' figures, the rate of return would need to be even higher. A basic rate tax payer would need an initial 1% of growth per annum whilst a higher rate an additional 1.67% per annum.

This is all fine in theory if the returns are realistic for the funds that match the attitude to investment risk. It may mean that a very cautious investor either has to review their risk stance and accept a higher level of risk, or even consider alternative contracts, such as the more traditional annuities or 'third way' pension income contracts that can guarantee a death benefit, some flexibility and some exposure to investment growth.

It works both ways too. Often as advisers we re-evaluate a client's attitude to risk in addition to their goals and establish that they need not take the level of risk they are, recommending that they in fact reduce the risk of their portfolio.

If the pension fund has to last a lifetime, it is essential to identify realistic goals, ensure regular reviews and get the right advice for you.