Are you the right sort for a drawdown?

So you want to delay buying an annuity? Be careful, warns Matthew Craig

WHILE BILLIONS of pounds in compensation is being spent clearing up the personal pension mis-selling debacle, financial pundits are speculating on the next possible financial services disaster.

Endowment mortgages, guaranteed investment funds, pension top-ups and group personal pensions have all been tipped as problem areas, but income drawdown is widely seen as having the most potential for a scandal.

Income drawdown allows an investor to delay buying an annuity (a contract to swap a pension fund for an annual income) when he or she retires. Instead, part of the pension fund is taken as income, while the rest of the fund stays invested and continues to grow.

More than pounds 3.5bn from thousands of investors has gone into income drawdown in the last three years, but some experts now say the product is only suitable for a very limited market. Until 1995 people retiring with a personal pension or company money purchase scheme had to buy an annuity as soon as they retired. The rates were affected by stock market and interest rate movements, so that some people simply lost out.

When the first income drawdown plans were sold, the product was seen as a way of avoiding having to buy an annuity on unfavourable terms. By using income drawdown, so the thinking went, investors would be able to wait for annuity rates to improve.

Annuity rates paid out an average annual rate of 8 per cent of the total pension fund in 1995. These rates were seen as low in historic terms, but have fallen to around 5.5 per cent now. And with European economic and monetary union (EMU) just around the corner, many experts feel interest and annuity rates will fall further.

The way annuities are priced also penalises investors who delay buying an annuity. This is because of what is known in the actuarial jargon as "mortality drag", which means that as investors get older they lose the subsidy on annuity prices from those who die early.

So, despite the rising stock markets of the last few years, many income drawdown investors will have lost out by delaying buying an annuity.

But once you have made the decision to delay, you need to leave your pension invested for several years. Ronnie Lymburn of the Income Drawdown Advisory Bureau says that falls in stock markets and annuity rates have heightened fears that anyone using income drawdown for less than five years could lose out. Many experts now say individuals should have a pension fund of around pounds 250,000 before they consider going into income drawdown.

Geoff Pointon, managing director of Pointon York, a pension specialist, says he is very nervous about income drawdown being used to try to beat annuity rates. He comments: "The only people who should be allowed to do drawdown are those with substantial assets, so they can take a higher risk approach."

However, a survey by specialist magazine Pensions Management earlier this year found that the average pension fund invested in income drawdown was only pounds 123,230. This figure does not include investors' assets outside these schemes, but it raises fears that investors with insufficient funds may have taken out drawdown plans.

Not everyone in the industry agrees that there should be a minimum investment for income drawdown. Steve Muir, AXA Sun Life pensions marketing manager, says: "There will always be cases that come in under the limit where drawdown is suitable."

Some investors have not been generating large enough returns on their invested pension fund because they have been advised to move their money to cautious with-profit funds. According the Financial Services Authority (FSA), 53 per cent of drawdown investment is in with-profit funds.

With-profit funds are usually invested about 75 per cent in shares, with the remainder in fixed interest, money and property. They are usually marketed as having a lower-risk profile and lower potential returns than pure stock market funds. (Most endowment policies, for example, are invested in with-profit funds.) Scottish Widows is refusing to put income drawdown investors into with-profit investments, so some experts are clearly aware there may be big problems in future.

Even more worryingly, some investors have almost certainly been pushed into unsuitable funds by commission-hungry salesmen. Some pension companies offer up to 6 per cent initial commission and up to 1.5 per cent annual renewal commission on pension funds transferred into drawdown schemes. The market norm appears to be 3 per cent initial and 0.5 per cent renewal. In comparison, the commission payable on annuity purchase is not generally more than 1.5 per cent of the annuity cost.

High commission levels also make it more likely that drawdown investments will fail to keep pace with annuity prices. Mr Pointon comments: "The effect of taking maximum commission up front is to make a serious hole in the pension fund, before drawdown has even started."

Concern at possible mis-selling of income drawdown has led the Personal Investment Authority (PIA) to issue revised guidelines for financial advisers (IFAs) on the question.

Roddy Kohn, an IFA at Kohn Cougar in Bristol, said that it was vital that advisers communicated the risks involved to investors. "With hindsight, you can say it might not have been a good idea, but most people understand what the risks are," he says.

"A lot of it is common sense - if you take an income of 10 per cent, there is a risk of eroding the capital."

Many advisers say that income drawdown is extremely useful for high net worth individuals, particularly when combined with products like a self- invested personal pension (Sipp) to give investment flexibility and scope for advantageous tax planning.

Lymburn describes the ideal drawdown investors as a married couple, both investment aware, who plan to retire early and take the minimum income from their pension fund.

But for the first wave of income drawdown investors, the change in advice may have come too late.

Matthew Craig is deputy editor, 'Pensions Management' magazine.

jargon buster

ANNUITY A contract made at retirement to swap most of your pension fund for an annual income for the rest of your life. The market is competitive, with some companies offering much better deals than others, so it is vital to do some research before you buy.

INCOME DRAWDOWN Also called a deferred annuity. This is a policy that allows you to leave most of your pension fund intact and invested, while you take an income each year. The idea is that you invest the rest to beat the rates you would have got from a standard annuity contract. Also, your family has access to the cash left invested if you die before taking an annuity.

These deals are suitable for those with a lot of money to invest - experts suggest pounds 250,000 or more. Some life companies run income drawdown schemes that will accept far less than this. Be careful when you take advice: sometimes excessive commission of up to 6 per cent is on offer to an adviser who sells you a life company income drawdown scheme.