Income drawdown contracts are more complicated and more costly than annuity purchase and are in some respects more risky than an annuity purchase. For this reason you will find at least one "critical yield" on an income drawdown illustration.

Income Drawdown and "critical yields"

The main critical yield you will see on any illustration is a "type A" critical yield. This is typically between 6%-8%. What it aims to show is how much growth you would need from an income drawdown contract to provide the same income as buying an annuity. The higher the critical yield, then the more difficult it is to justify in mathematical terms entering into an income drawdown contract rather than buying an annuity.

This comparison is flawed in many respects, since it uses certain assumptions about interest rates, and won't always use the annuity you would/could have bought.

e.g. if the income drawdown company providing the income drawdown illustration is one which offers some of the worst annuity rates, then the critical yield will in reality be higher than quoted, since you could have taken an annuity with a provider offering better annuities. The same applies if you smoke or have health problems, since the income drawdown illustration will not take that into account.

If you asked the income drawdown provider to compare drawdown to a joint life 100% spouse's pension, with inflation proofing, then it is likely that the critical yield would be lower.

Another type of critical yield you might see on an income drawdown illustrations is a "type B critical yield". This shows the growth required to maintain the level of income you wish to withdraw. This is in some ways more useful, as it is based on your circumstances. It is pretty much common sense, since the greater the income you want to take from the income drawdown contract then the higher the type B critical yield. But even this can be meaningless if you do not intend to draw any income from your plan, and only wish to take the tax-free cash from the plan or a portion of the fund, if for example you took out a phased income drawdown plan.

Income Drawdown and the Risks

In many ways an income drawdown is more risky than buying an annuity. It is possible that:-

• The income drawdown fund value may fall, and your income may go down
• The fund value could rise and the amount of income you could withdraw could still fall if the GAD rates go down
• Annuity rates may go down if you ultimately decide to buy an annuity

However there are also risks in buying an annuity since to a degree you need to predict the future to make the best decision for you. You need to decide at the outset whether you:

• Opt for a joint pension if you're married or have a partner, which will mean a lower income and is pointless and irreversible if your spouse dies before you
• Opt for inflation proofing which again means a lower initial income, which could be pointless and poor value if there is low inflation and/or you die relatively soon.
• Opt for a level annuity. This could prove disastrous if you live a long time, and/or there is a period of high inflation, since its real buying power will be reduced
• There is also the common criticism of annuities in that they can represent poor value for money if you die relatively soon, since it is argued it subsidises those who live longer than you or is a windfall for the annuity provider

Reducing the risks of income drawdown

There are a number of strategies that can be employed to reduce the risks attached to income drawdown. One of the main ways is to opt for an appropriate investment strategy.

The type of funds available for income drawdown contracts are:

Equities - in other words share based funds. The risk of the fund falling in value depends on where the underlying funds are invested. High risk companies such as technolgy companies pose a greater risk than ones that invest in Blue Chip shares such as Tesco or BP.

Property Funds - there are funds that invest in Property. Historically this has been commercial property, but there are now some companies that offer funds which invest in residential property.

Fixed Interest - these are effectively traded "IOUs". Both companies and governments who wish to raise money issue this type of financial product. It states that they will pay an amount of interest to the holder, and either return the capital in the future or perhaps have no redemption date. The risks of this type of investment depends on the issuer. The lowest risk ones (and generally lowest return ones) are those issued by the UK Government - these are called Gilts. The ones issued by companies vary in risk and return, depending on the financial standing of the company.

Cash/Deposit based funds - these type of funds work like a deposit account, and are the lowest risk type of investment. They would pay interest just like a bank or building society account.

For most people and their income drawdown contract it is probably best to have a mixture of these types of funds. The proportion would depend on your attitude to risk. 

Spreading the risks:
When you take out an income drawdown contract you need a certain amount of growth to match the income available from an annuity. It is unlikely that a very low risk investment approach would meet this level of growth. So you need to opt for funds which offer real returns over and above inflation, such as shares and property. It would be unlikely that a cash/deposit based fund, would provide sufficient growth.

It would even be unlikely that a Gilt fund or fixed interest fund would meet the required level of growth, since these are the types of investment that are ultimately used to provide an annuity, and there is the loss of the mortality cross subsidy - i.e. the people dying early who provide additional income to those who live longer.

Using a cash fund to reduce income drawdown risks

For the majority of people there is a need to include share based funds within their income drawdown contract, and for many it also makes sense to include some property too. There is however the risk that these types of funds can fluctuate in value especially over the short term. One way of reducing this risk is to invest a proportion of the fund in a cash/deposit based fund.

e.g. Mr Jones has a fund of £100,000 after taking tax-free cash from the plan. He requires an income of £5,000 per year, and wants the majority of his fund invested in share based investments.

He has concerns that the fund could fall in value. To reduce the impact of any fall in the value of the share based fund, he invests £15,000 into a cash fund. This will give a return of around 3%-4%, so it provides some return. The remaining funds of £85,000 are invested in a wide range of share based funds.

At the end of year one, the equity element has fallen to £75,000 due to a stockmarket slump, but he has taken his income for the year of £5,000 from the cash element. He has not been forced to use his share element to provide his income when they have fallen in value.

At the end of year two, the stockmarket, and his equity funds have recovered and are now worth £89,000, and he has also taken his income from the deposit element. He now has £89,000 in equities and £5,000 left in deposit, and has also taken income of £10,000.

At the end of the third year the to equity element has grown further, and is now worth £101,000, and he has also taken £5,000 of income from the deposit element.

By using this investment approach within his income drawdown plan Mr Jones was able to avoid using the share based funds to provide an income when they had fallen in value, and so was able to benefit in the event of a recovery.

The above example is one method of reducing the risk. The numbers are made up, as is the client. It would have been possible in year one to place all the fund in a cash/deposit based funds and totally avoid any fall in the stockmarket., and change the funds at a later date. Additionally it may have made sense at the end of year two to put more money into a cash/deposit based fund. The example also ignores any return on the cash/deposit element.

If you have a question about income drawdown or want to discuss drawdown in more detail and how it can benefit you then contact us online or phone 0800 011 2713 , or click on the links below to find out more.

Income drawdown - providers and options

Unsecured Pension - if you want to know more about the options for those under 75

Alternatively Secured Pension -  if you want to know more about the contract for those over age 75

Don't take any chances with your pension, your retirement will depend upon it, talk to an independent pension annuity specialist now