Drawdown Pensions

PLEASE NOTE, FROM 6TH APRIL 2015 THE NEW PENSION FREEDOMS COME INTO EFFECT AND DRAWDOWN WILL BE KNOWN AS FLEXI-DRAWDOWN. THE INFORMATION BELOW IS PRE 5TH APRIL 2015. MORE INFORMATION ON THE NEW FREEDOMS TO FOLLOW SHORTLY OR CAN BE FOUND ON OUR BLOG…….

Drawdown Pensions / Unsecured Pension (DP)

Drawdown Pension is only available from money purchase schemes (or by first transferring into a money purchase scheme, which is likely to involve charges). There are two types of drawdown pension arrangement, income withdrawal and short-term annuity, and these are both considered below. In addition, phased retirement can be used with drawdown pension and this is also described in this section.

All income from drawdown pension or short-term annuity contracts (if it exceeds your Personal Allowance) is subject to income tax in the same way as earnings.

Drawdown Pension

You do not have to buy an annuity when you want to start taking an income from your pension fund. Instead, you can put off buying an annuity, perhaps indefinitely, and in the meantime, you can take an income direct from your pension fund. This facility is referred to as Drawdown Pension.

If you want to take part of your pension fund as a tax-free lump sum (usually up to 25% of the fund) you do this before starting to take income from the fund.

Depending on your personal circumstances, Drawdown Pension is available on either a Capped or Flexible basis as described below:

Capped Drawdown

The maximum amount of income that can be drawn is 150% of a comparable lifetime annuity based on tables published by the Government Actuary’s Department. It is not however necessary for any income to be taken. Any amount of income from zero through to 100% of the maximum available can be selected. The plan and maximum income will be reviewed every 3 years up to the anniversary of entering drawdown after the 75th birthday and annually thereafter.

Flexible Drawdown

If you have an income that meets the Minimum Income Requirement (MIR) of at least £12,000 per annum you will be able to draw down an unlimited amount from your drawdown pension funds and not be subject to the Capped Drawdown limits described above. The MIR is the same for all ages, applies to each individual, and will include State Pension Benefits (both Basic and Additional), Final Salary Pensions, Level Lifetime Pension Annuities and Scheme Pensions. Types of income that will not count towards the MIR include Purchased Life Annuities, other State benefits and Drawdown Pension income.

To enter Flexible Drawdown you will need to self certify that you meet the MIR. Having entered Flexible Drawdown there will be no restriction on the income you are able to draw. While in Flexible Drawdown you will however be unable to make further pension contributions (this includes any further benefit accrual under a final salary pension scheme).

All income taken, whether under Capped or Flexible Drawdown, is taxable as earned income.

You should think about reviewing your income every year as well as the decision on whether it might be appropriate to purchase an annuity at that point.

The last few years have seen the launch of a number of products based on Drawdown Pension (formerly income withdrawal) which offer income guarantees – these products are basically Drawdown Pension plans with some level of underpinning income guarantee which will continue no matter how the underlying investment fund performs. Some plans provide an income for life whilst with others income is guaranteed for a specific time period.

If you die whilst drawing an income from the plan your dependants will have the option of continuing to take Drawdown Pension, buying an annuity or taking the remaining fund as a lump sum, with liability to tax at 55%.

It is also possible to combine Phased Retirement with Drawdown Pension and this is looked at in more depth in a later section.

Advantages

    • Subject to limits imposed by legislation, you will be able to plan in advance the level of income that you wish to take each year, so that you can take into account any other sources of income which may become available to you.
    • You can structure your income to mitigate liability to personal income tax.  By reducing your income in some years you may be able to avoid a higher rate tax liability.
    • If you have sufficient income to satisfy the Minimum Income Requirement (MIR) you may withdraw an unlimited amount from your pension fund, although all amounts withdrawn will be taxed as income at your highest marginal rate(s).
    • There are products available which offer a level of guaranteed income which is paid regardless of the performance of the investments in your pension fund thereby removing some of the risk involved with Drawdown Pension (albeit at a price and subject to specified conditions being met).
    • If the Drawdown Pension product is set up within a Self Invested Personal Pension (SIPP) wrapper, this will permit access to a wide range of investments and enable the investments to be rearranged easily if required (and usually more cost effectively than switching between product providers).
    • You can take your tax free cash lump sum immediately to spend or invest as you wish without the need to take any income at all if this suits your circumstances.
    • The pension fund value (less any income withdrawn and associated charges) will continue to be invested for you either indefinitely or until you decide to purchase a Lifetime Annuity.  Depending upon investment returns, which can fall as well as rise and are not guaranteed, this may provide the opportunity to achieve sufficient growth to improve your ultimate benefits if you decide the time is right to purchase a Lifetime Annuity.
    • If you or your spouse is relatively young, a secured pension (lifetime annuity or scheme pension) would be less attractive due to the lower mortality factor and, in addition, there is a longer timescale to take advantage of the potential investment rewards and risks of Drawdown Pension.
    • You can delay purchasing a Lifetime Annuity if you think annuity rates will improve.
    • As you get older there is the prospect of annuity rates rising and providing you with higher income.  This is because life expectancy is shorter for someone older and it therefore costs less to provide them with the same given level of income than for a younger person, assuming all other things being equal.
    • On death, the remaining pension fund (i.e. the portion not being used to provide income) can be returned to your beneficiaries, normally free of Inheritance Tax and the 55% income tax charge.

Disadvantages

    • Drawdown Pension products tend to have higher charges than Secured Pension products due to the greater amount of administration and advisory input they involve.
    • Investing in relatively safe areas such as cash and gilts is unlikely to enable a higher lifetime income to be achieved than with a secured pension therefore investing in the type of assets that might achieve the extra returns necessary will involve risk. The shorter the term to the intended date of purchasing a secured pension, the greater the risk.
    • Annuity rates may be at a lower level when annuity purchase takes place and there is no guarantee that your income will be as high as that offered under the other options referred to earlier.
    • There is no guarantee that annuity rates will improve in the future.  They could be lower if/when you decide to purchase an annuity than they are currently.  Your pension may be lower than if you bought a lifetime annuity now.
    • The value of your pension fund may go down as well as up and investment returns may be less than those shown in the illustrations.
    • Taking withdrawals may erode the capital value of the fund, especially if investment returns are poor and a high level of income is being taken. This could result in a lower income if/when an annuity is eventually purchased.
    • High levels of drawdown pension may not be sustainable in the longer term.
    • Death benefits which are not paid to your spouse or dependants might be liable to Inheritance Tax.
    • Death benefits payable as a lump sum, from the portion of the pension fund being used to provide income, are subject to 55% income tax.
    • You may feel the possibility of future higher income does not compensate for the guaranteed level of income available today, and for the rest of your life, that a conventional lifetime annuity provides (although, as mentioned earlier, there are now Drawdown Pension products available which offer a guaranteed level of income regardless of fund performance).
    • Annuity providers make a profit from the fact that some individuals die sooner than is expected. They utilise some of this ‘mortality profit’ to enhance current annuity rates. By delaying the purchase of your lifetime annuity, the benefit of this potential profit, which can be significant, may be lost.
    • If investment returns do not at least match the critical yield (in simple terms, the value of growth required to provide an equivalent income at  the age you intend to purchase an annuity) your eventual income is likely to be less than that which could have been available at outset.
Short Term Annuity

After taking your tax free cash lump sum, your fund is initially divided into two separate elements. The first element will be used to secure a temporary annuity not exceeding five years. As a temporary annuity costs less to provide than a similar lifetime annuity, the bulk of your fund will be available for investment. The maximum initial income that may be paid by the temporary annuity is calculated on the same basis as Drawdown Pension (see above).

After the chosen period the temporary annuity will cease and you then have three options with the remaining invested part. You can decide to secure another temporary annuity, use Drawdown Pension (see above) or buy a lifetime annuity/scheme pension (see earlier sections). You may repeat this process over and over again.

Additional pension benefits can be taken before the end of the term of the existing short-term annuity contract. Where Drawdown Pension is used or additional short-term annuity contracts are purchased the level of income already paid, or to be paid, from the existing annuity contract must be taken into account when considering how much additional Drawdown Pension/Short term annuity can be paid or secured.

As with standard annuities, there is no return on death unless you select an annuity certain (which guarantees payment of the annuity for the term chosen even if you should die sooner) and or a spouse/dependant’s pension. However, this product does allow you to change the spouse/dependant’s pension provisions at each review to reflect changes in your circumstances.

Advantages (many of which are the same as Drawdown Pension)

    • Subject to limits imposed by legislation, you will be able to plan in advance the level of income that you wish to take each year, so that you can take into account any other sources of income which may become available to you.
    • You may be able to structure your income to mitigate liability to personal income tax.
    • You receive a guaranteed level of gross income over the term chosen (up to 5 years).
    • Your spouse/dependant(s) can enjoy a guaranteed level of gross income, in the event of your death (if applicable).
    • Your pension can be guaranteed for the full five years (or selected term if less) by choosing an ‘annuity certain’.
    • You will be able to take your full tax free cash lump sum immediately to spend or invest as you wish.
    • The pension fund value (less the amount used to purchase the short-term annuity and associated charges) will continue to be invested for you until you decide to purchase further short-term annuities, a Lifetime Annuity or Drawdown Pension.  Depending upon investment returns, which can fall as well as rise and are not guaranteed, this may provide the opportunity to achieve sufficient growth to improve your ultimate benefits when you decide the time is right to purchase a Lifetime Annuity or Drawdown Pension.
    • If you or your spouse is relatively young, a secured pension (lifetime annuity or scheme pension) would be less attractive due to the lower mortality factor and, in addition, there is a longer timescale to take advantage of the potential investment rewards and risks of Drawdown Pension.
    • You can delay purchasing a Lifetime Annuity if you think annuity rates will improve.
    • As you get older there is the prospect of annuity rates rising and providing you with higher income.  This is because life expectancy is shorter for someone older and it therefore costs less to provide them with the same given level of income than for a younger person, assuming all other things being equal.
    • On death, the remaining pension fund (i.e. the portion that has not been used to purchase short-term annuities or other pension products) can be returned to your beneficiaries, normally free of Inheritance Tax and the 55% income tax charge

Disadvantages (many of which are the same as Drawdown Pension)

    • The level of income is fixed for the term chosen (up to 5 years) and cannot respond to changing personal financial circumstances (although if the maximum level of income is not being taken, it is possible to purchase an additional short-term annuity or use Drawdown Pension to achieve income up to the maximum allowed. Alternatively, a lifetime annuity could be purchased with some or all of the remaining pension fund.)
    • If using capped drawdown income levels must be reviewed at least every 3 years prior to age 75 and annually thereafter and at a review the level of income will depend upon annuity rates at that time and may be smaller than the income received at outset.
    • The rate of growth needed within the investment element to provide an annuity at the end of the chosen period which is at least equal to the annuity level at outset may not be achieved.
    • In the event of death, benefits for your dependants could be lower than those enjoyed under some of the other options available to you and briefly explained in this guide.
    • Investing in relatively safe areas such as cash and gilts is unlikely to enable a higher lifetime income to be achieved than with a secured pension therefore investing in the type of assets that might achieve the extra returns necessary will involve risk. The shorter the term to the intended date of purchasing a secured pension, the greater the risk.
    • Annuity rates may be at a lower level when annuity purchase takes place and there is no guarantee that your income will be as high as that offered under the other options referred to earlier.
    • There is no guarantee that annuity rates will improve in the future.  They could be lower when you decide to purchase your annuity than they are currently.  Your pension may be lower than if you bought a lifetime annuity now.
    • The value of your pension fund may go down as well as up and investment returns may be less than those shown in the illustrations.
    • Taking withdrawals (in order to purchase short-term annuities or via Drawdown Pension) may erode the capital value of the fund, especially if investment returns are poor and a high level of income is being taken. This could result in a lower income if/when an annuity is eventually purchased.
    • Using short-term annuities to take high levels of income may not be sustainable in the longer term.
    • Death benefits which are not paid to your spouse or dependants might be liable to Inheritance Tax.
    • Death benefits payable as a lump sum, from the remaining pension fund (i.e. the balance after short-term annuity purchase) are subject to 55% income tax.
    • You may feel the possibility of future higher income does not compensate for the guaranteed level of income available today, and for the rest of your life, that a conventional lifetime annuity provides (although, as mentioned earlier, there are now Drawdown Pension products available which offer a guaranteed level of income regardless of fund performance).
    • Annuity providers make a profit from the fact that some individuals die sooner than is expected. They utilise some of this ‘mortality profit’ to enhance current annuity rates. By delaying the purchase of your lifetime annuity, the benefit of this potential profit, which can be significant, may be lost.
    • If investment returns do not at least match the critical yield (in simple terms, the value of growth required to provide an equivalent income at the age you intend to purchase an annuity) your eventual income is likely to be less than that which could have been available at outset.
Phased Retirement using Drawdown Pension

It is also possible to combine Phased Retirement with Drawdown Pension which would mean that you would start to draw an income from just part of your pension fund on one date including the tax free cash sum available from that part, leaving the rest of the fund intact. To increase your income at a later date, you could either increase the rate of withdrawal (provided you did not exceed the maximum limit if using Capped Drawdown) or start to draw an income, including the tax free cash sum, from a further slice of your pension fund.

Each time you start using a segment (or portion of your pension fund) for Drawdown Pension, you can first take part of the portion’s fund as tax-free cash (normally 25% of the portion). Converting portions of the fund regularly, for example once a year, means you can effectively use the tax-free cash, as well as the Drawdown Pension payments, to provide your income. The drawback is that if you stagger the conversion of your pension fund into Drawdown Pension, you will not be able to take all your tax-free cash from your total pension fund at once as a single lump sum.

Phased retirement can be a very useful financial planning tool, for example, if you want to ease back gradually on work and start to replace your earnings with pension income. It also provides more flexible help for your survivors if you die. On death, the balance of the pension fund that has not yet been used for Drawdown Pension can provide a pension for your surviving dependants or a lump sum, depending on the terms of the pension plan. Phased retirement is generally suitable only if you have a fairly large pension fund, or have other assets or income to live on. This is because the bulk of your pension savings remain invested, usually in the stock market, which may be more risky than buying an annuity straight away.

Advantages

    • You can use tax free cash as ‘income’ and thus, for a given level of income, reduce your overall liability to Income Tax.
    • The balance of your pension fund not used for Drawdown Pension continues to be invested, thus providing you with the possibility of higher future income.  This depends largely on how much income you take out of the pension fund (especially in the early years) and future investment returns achieved on the residual pension fund.
    • As you get older there is the prospect of annuity rates rising and providing you with higher income.  This is because life expectancy is shorter for someone older and it therefore costs less to provide them with the same given level of income than for a younger person, assuming all other things being equal.
    • If your market expectations are that medium to long-term interest rates and gilt yields may rise, annuity rates might also rise.  If this happens, you will be able to achieve a higher amount of income, through the purchase of an annuity, for the same amount of pension fund.
    • You will be able to change the shape of your retirement income to reflect your personal circumstances in the future. Should your health deteriorate, it may be possible to achieve a better annuity rate (ie. higher income) in future. It is also possible to postpone the choice of whether to include any spouse/dependant’s pensions until a lifetime annuity is purchased – this could be valuable for someone whose spouse is in poor health.
    • Any remaining pension fund that has not been used for Drawdown Pension can be returned to your beneficiaries as a lump sum normally free of Income Tax and Inheritance Tax on your death before age 75. On death after age 75, an income tax charge of 55% will be due on the value of the remaining fund (unless paid to charity) but there should be no liability to Inheritance Tax. Funds used to provide a dependant’s annuity will not be subject to the 55% tax charge – the annuity will however be taxed as income in the hands of the dependant(s).

Disadvantages

    • There is no guarantee that your income will be as high as the income available under the Lifetime Annuity routes referred to earlier.
    • Deferring the purchase of the annuity does not guarantee a higher level of future income and the value of your remaining pension fund, when aggregated with any income you have taken, may not achieve the required level of growth to maintain income levels at the same level as could be achieved through the purchase of a conventional Lifetime Annuity with the entire pension fund (excluding tax free cash) at outset.  This is because withdrawals of tax free cash and income withdrawals may erode the value of your pension fund if investment returns are not sufficient to make up the balance (including charges for the ongoing administration of the plan).
    • You may feel that the possibility of future higher income does not compensate you for being unable to enjoy a guaranteed and secure level of income today and for the rest of your life.
    • You will not receive all of your tax free cash as a lump sum at outset, because you are accessing your pension fund gradually over time and using the cash to supplement your income.

Annuity providers make a profit from the fact that some individuals die sooner than is expected.  They utilise some of this ‘mortality profit’ to enhance current annuity rates.  By delaying the purchase of annuities the benefit of this potential profit, which can be significant, may be lost.

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