Income drawdown in Sipps: Drawdown squeeze

By stripping down the elements that make up a drawdown review, you can present a picture of why the maximum has fallen. To demonstrate this, let us look at a fictional – yet not atypical – client.

Susan was 60 when she started her drawdown in 2007 with a £530,000 pot. The drawdown rate – or Gad rate – for a 60-year-old female at that time was 6.6 per cent, and Susan was allowed to draw 20 per cent more than this. This resulted in a maximum pension of £41,976 pa.

She drew her pension at the maximum rate and five years later her fund had fallen to £440,000. Her maximum pension fell by almost half to £22,440 pa. This was a 47 per cent drop compared with a 17 per cent drop in her fund. How did that happen?

Susan’s maximum pension depends on various factors. We can analyse each element separately by changing one variable at a time and begin with assuming that the drawdown rules and gilt yields were exactly as they were back in 2007.

Fund performance and Gad

The Gad rate for a 65-year-old in 2007 was 7.2 per cent. Ignoring other factors, this implies Susan had to target a fund of around £486,000 in 2012 to have continued drawing the pension of £41,976 pa. Her fund was only £440,000, a shortfall of £46,000.

By drawing the maximum pension every year since 2007, Susan had effectively drawn six years’ worth of drawdown over a five-year period. This would only be sustainable if Susan’s fund was performing sufficiently well to support the extra £34,980 that was withdrawn.

If you don’t have much data, you could estimate that £35,000 of the £46,000 shortfall was due to the additional pension being drawn. With interim fund values it is possible to make better assessments and, by looking at annual statements, £39,000 is calculated to be a closer estimate.

We can conclude that her maximum pension of £41,976 reduced slightly to £41,405 due to fund performance not meeting expectations, but further reduced to £38,016 because Susan had drawn the 20 per cent extra each year.

Longer life, less uplift

The removal of the 20 per cent uplift, effective from 6 April 2011 as part of a range of measures to bring in lifetime drawdown rules, dropped Susan’s maximum pension from £38,016 pa to £31,680 pa.

Drawdown rates were updated in 2011 to take account of improving longevity, which resulted in the tables moving away from market annuity rates. The impact of this depended on age and gender, but was more pronounced for older males. The new rates for a 75 year-old male were some 7 per cent worse than the old ones.

For Susan, the change meant a small drop in her maximum pension from £31,680 to £31,240 - about 1 per cent.

Gilt yields

This leads us to the largest contributor to Susan’s reduced maximum. If gilt yields had remained at 5.25 per cent, her maximum pension would only have fallen by about a quarter. This was primarily due to the removal of the 20 per cent uplift but the five years of additional pension drawing also contributed significantly.

The fall in gilt yields had a great impact on the maximum drawdown rates, as illustrated in Chart 1, with 15-year yields dropping from 5.25 per cent to 2.25 per cent. Susan’s drawdown rate therefore fell from 7.1 per cent to 5.1 per cent, resulting in her maximum pension reducing to £22,440 pa. The validity of the drawdown rates is also brought into question as they drifted away from market annuity rates, as shown in the chart.

Of course, had Susan followed an investment strategy that matched gilt yields, this fall could have been compensated by investment performance. The relatively good fund performance of her Sipp should be taken in the context of being good compared with what was expected in 2007.

The combined impact of all of these factors can be seen in Chart 2, which breaks down the fall in the amount she could draw.

Future increases

For clients affected by these issues, there are two pieces of good news.

At Susan’s next compulsory review date, her maximum drawdown will be based on male rates following the ruling by the European Court of Justice that insurance products should not take account of gender.

This affects drawdown as male rates are to be used for everyone until unisex rates are brought in once the annuity market has settled. This means Susan’s drawdown rate will be some 7 to 8 per cent higher, as seen by the sharp rise in her spot Gad rate in Chart 1 at the end of 2012.

Second, and more significantly, the 20 per cent uplift has been restored for drawdown years starting on or after 26 March 2013. While this sensibly does not require a compulsory review – the maximum just increases by 20 per cent – it is up to drawdown providers to implement this. Some may delay bringing in the 120 per cent maximum due to necessary system amendments or even charge due to payroll records needing updating.

It is important to note, however, that both of these amendments do not change the actual level of sustainable pension that is appropriate for Susan to draw if she requires a stable pension for life. They change the pace at which Susan can draw her income, but they do not create additional wealth for Susan.

The ability to draw more out in earlier retirement years may, of course, be precisely why Susan opted for drawdown in the first instance; that is why it was important for the government to bring back an element of flexibility for those in drawdown. Sipp-holders approaching or in drawdown now need confidence that further changes will not be made.

Andrew Roberts is partner at Barnett Waddingham