Draw a bigger income from your pension pot

If you are prepared to risk leaving your pension invested in the stock market, you can enjoy an annual income which could be hundreds of pounds higher than you would get from the best annuity.

Unsecured pension (USP) - or income drawdown - allows you to draw an income directly from your pension fund, without the need to buy an annuity. (An annuity converts your pension fund into a guaranteed income for the rest of your life,)

I can hear a huge cheer from those of you who hate the idea of sacrificing your pension pot to an annuity company and being stuck with low annuity rates for the rest of your lives. Clearly, USP sounds like the perfect solution. But is it?

How does USP work?

With USP, your pension fund remains invested in the hope of providing more capital growth in the future. The idea is that the fund performs well enough to provide you with a better income than you would have got from an annuity. (You still have the option of taking up to 25% of the pension as tax-free cash, just as you would with an annuity).

Many people use USP for a time, before buying an annuity with the remaining pension fund later on. This is because you can only leave your money invested in your pension until the age of 75.

But if you want to, after you turn 75, you can still avoid buying an annuity by choosing an Alternatively Secured Pension (ASP) instead. ASP is broadly similar to USP. It enables you to carry on taking an income from your invested pension fund far into your retirement.

The income you take from USP is subject to limits set by the Government Actuary's Department (GAD). GAD limits generally allow you to take up to 120% of the income that would typically be provided by a conventional annuity for someone of your age, gender and pension fund. You can vary the income you take between zero and the maximum as required.

Confused? The key fact to bear in mind is that, if you want to, you are allowed to draw down an income which can be as much as 20% higher than you would get from a typical annuity.

USP income withdrawals

Let's assume you have a pension pot of £100,000 which you move into USP. The table below shows how much income you could draw down, based on current GAD limits, as well as your age and gender:

The maximum income a male, age 65, can draw from USP is currently £8,160 a year. But if he chose the very best conventional annuity available on the market today, he would get an income of just £7,375 a year. So, with USP he could be up to £785 better off every year.

Still, this is only around 11% higher than the annuity. Where's the missing 9%? 

Unfortunately, the maximum income GAD allows you to take is 120% of a typical annuity, as calculated by the GAD boffins, for someone of your age, gender and pension pot. So you won't necessarily be able to draw down 120% of the absolute best available annuity you can find. But you should still be able to draw a significantly larger income from your pot with USP, than if you use that pot to buy an annuity.

So, we've looked at how USP works and got a feel for the amount of income it might provide. But is USP really better than an annuity? Let's take a look at more of the pros and cons:

The advantages of USP

• USP is far more flexible than an annuity. The income you take can be varied to suit your changing circumstances (within the specified GAD limits). 
• If your pension fund performs well, the extra capital growth may allow you to draw a larger income than you would get from an equivalent annuity.
• Death benefits are more generous under USP. They can provide a pension for your dependants or pay them a lump sum (or a combination of both). Lump sum death benefits attract a 35% tax charge. By contrast, annuity income is completely lost on death unless you pay for a guarantee. And even then it will only pay out for a maximum of ten years if you die sooner. You could buy a joint life annuity which pays some, or all, of your annuity to your dependant after your death, but this will reduce the income you initially receive in your own right.
• Even if you are using USP, you can switch over to an annuity with some, or all, of your remaining pension fund at any time.
• Delaying when you buy an annuity could be beneficial. That's because annuity rates will be higher the older you are (to compensate for the annuity paying out for a shorter period of time because you're older), so you should enjoy an age-related uplift when you come to buy one.
• USP can be phased which allows you to move parts of your pension fund into USP at different times as required giving you more flexiblity.
• If you're currently invested in the stock market, your fund is likely to have suffered losses over the past year. By buying an annuity now, you would crystallise those losses. If you believe the stock market will recover over the next decade, it may be wiser to remain invested.

The disadvantages of USP

• An annuity offers a guaranteed income for life. You will not get that sort of peace of mind with USP.
• The charges are generally higher for USP than a conventional annuity.
• Your pension fund remains invested which involves ongoing investment risk. It's unlikely your USP plan could provide an income that beats an annuity by investing in 'safe' assets. Some degree of risk will be necessary, usually by investing in the stock market. Your fund needs to reach a 'critical yield' where it can provide at least the same level of income as an equivalent annuity.
• That means your pension fund might not perform well enough, and you could be worse off than you would have been by choosing an annuity.
• You will need to review your USP regularly to ensure the withdrawals made, and the investment performance hasn't eroded the fund value too much.
• You may have to reduce the level of income you draw if your fund is not performing well.
• Taking a gamble on annuity rates is risky particularly if you intend to take USP now, but buy an annuity later on. If annuity rates have fallen over that period, you could end up with a lower income.
• GAD limits are normally only reviewed every five years. If your pension performs particularly well, you won't be able to take an income greater than the maximum allowed.
• Annuities are very simple to understand. USP takes effort from you in terms of choosing investments and monitoring performance. You will almost certainly need the help of a financial adviser.

Is USP for me?

That's quite a lot of pros and cons to mull over. But think about this: USP is really only suitable if you have a pretty large pension pot to start with. That's because of the investment risks involved and the charges for setting up and running the plan. Typically, USP is only used by people with pensions of around £100,000 who don't need the certainty of a guaranteed income.

So, particularly if you have other sources of capital to pay for your retirement, you may decide the potential for an improved income from USP is worth the gamble. If, however, you're one of the many, many people who have a far smaller pension pot and you need a fail-safe income for life, I think an annuity is still a more suitable and secure choice for you.

More: Why printing money is bad news for pensioners | Twenty years of DIY pensions | Read more retirement and pensions articles at lovemoney.com.