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Pension Drawdown. What is it?
People generally save for retirement via a personal pension or a company pension scheme. In essence a pension plan is a compulsory purchase annuity, which means that the funds in your pension must purchase an annuity at retirement. If this is from a company scheme the calculation can vary depending upon the scheme, plus there can be benefits provided in the scheme such as spouses pension, death in service, plus index linking in retirement. If the scheme is a final salary scheme the pension is dependent upon the years of service plus final salary as defined in the scheme booklet. If the company scheme is money purchase it is dependent upon how much money is in your pot plus your age and what benefits you are going to have. Similarly personal pensions are money purchase and the eventual outcome is dependent upon how much money is in the pot, what benefits you require and how old you are.
A secondary factor to take into account is that currently the likelihood of us staying in the same job with the same employer for a 40 year period is far less nowadays than previously. It is far more common for us to have lots of different pensions all over the place from companies previously worked for plus in many cases several personal pensions, also back in the early 90’s quite a lot of us opted out of SERPS.
An opportunity presents itself to look at all of these schemes and amalgamate them all into the same pot and take control of your pension fund and retirement planning.
Some people, rather than using a pension fund to buy a pension annuity at retirement, may prefer to drawdown on their pension fund now and wait until they are older when annuity rates could be higher.
Pension drawdown was the original name for this pension product but in 1997 the Personal Investment Authority (PIA) changed its name to pension fund withdrawal. This concept was introduced by the Inland Revenue as an alternative buying a pension annuity. Pension fund withdrawal was originally introduced as part of the Pensions Act 1995 and integrated into the existing personal pension structure rather than create a new product.
It is possible for an individual to use pension fund withdrawal from an occupational pension scheme, called occupational drawdown, this is usually only considered if the tax free lump sum from the occupational scheme is greater than the 25% tax free cash from a personal pension. If it is less, an individual that wants to benefit from pension fund withdrawal will usually transfer to a pension.
When transferring to pension fund withdrawal, the individual can take all the tax free lump sum initially and then take an income between limits calculated by the Inland Revenue. These withdrawal levels are subject to minima (being 35.0% of the maxima) and maxima based on the Government Actuary's Department (GAD) tables on long-dated gilt yields that are reviewed every three years.
Every three years the pension fund is subject to a triennial review. At this point new GAD tables are applied to the individual and this could mean that the maximum income that can be withdrawn will change. This is because the individual is older and receive a higher income or if the gilt yields have fallen, a lower income.
On the death of the individual in income drawdown, their spouse will have a number of options. They could continue with the income drawdown until they are age 75 or until the time their deceased spouse would have reached age 75, whichever is the sooner. The spouse could purchase a pension annuity or take the whole fund as a tax free lump sum and pay a 35% tax charge.
Another alternative route one could take could be to use phased retirement where only part of their fund is used for a compulsory purchase annuity, however, by age 75 an annuity must be purchased.
Both pension drawdown and phased retirement will require a fairly large initial fund value in order to make it worthwhile, usually about £100,000. Some companies will take a lesser sum of money for a drawdown. It is also more suitable to individuals that continue to have other income sources to rely on such as working part-time or income from other pensions, such as a final salary pension. As the pension fund remains invested typically in equity based investments, the individual must be prepared for some volatility in the fund in the future.
It is possible that by delaying purchasing a pension annuity the individual, or their partner, will suffer from ill health and when the pension annuity is purchased, benefit from improved rates from impaired life annuities. There is also the potential for future growth in the fund and the tendency for annuity rates, and hence pension income, to increase with age.
With even larger funds of £250,000 or more, an open annuity could offer similar flexible benefits as pension drawdown but also the possibility on the death of the member, of leaving the residual pension fund to nominated beneficiaries.
Pension Drawdown
Advantages
The following are a number of advantages of pension drawdown that reflect the benefits of deferring taking a pension annuity until later:
- An individual will be able to take a tax free cash lump sum immediately to spend or invest as they wish. This option is not available through the phased retirement option but is available through the annuity and open market option.
- The level of income which may be drawn, is determined by the GAD. Income may be withdrawn up to the determined level but a minimum of 35% of this income has to be withdrawn within any 12 month period.
- Subject to the above limits, the individual will be able to plan in advance the level of income that they wish to take each year, so that they can take into account any other sources of income which may be available to them.
- The pension fund value (less any income withdrawn and associated charges) will continue to be invested until the individual decides to purchase an 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 the ultimate benefits when the individual decides the time is right to purchase an annuity. However, an annuity must be purchased no later than age 75. - The individual can structure their income to mitigate the liability to personal Income Tax. By reducing their income in some years, they may be able to avoid higher rate tax liability.
- Potential death benefits may be greater than under the conventional annuity route, although a 35% tax charge will apply to any lump sum death benefits payable under any policy from which they have started to draw income.
- The remaining pension fund (i.e. policies not being used to provide income) can be returned to the individual's beneficiaries, in pension form, free from Inheritance Tax and the additional 35% tax charge.
- The individual may be able to use a Pension Fund Withdrawal as part of their Inheritance Tax planning by using varying levels of income, within prescribed limits, and using all or part of the income to make gifts to take advantage of annual exemptions.
- They can delay purchasing their annuity if the individual thinks the rates will improve, although an annuity has to be purchased by age 75.
Disadvantages
The following are a number of advantages of pension drawdown that reflect the disadvantages of deferring taking a pension annuity until later:
- There is no guarantee that the individuals income will be as high as that offered under the pension annuity (or compulsory purchase annuity).
- The value of the pension fund may not achieve the required level of growth to maintain income levels at the same level to those achieved through the purchase of a pension annuity purchased at outset.
This is because income payments are technically withdrawals of pension fund capital and these payments may erode the value of the pension fund, if investment returns are not sufficient to make up the balance and this includes charges for the ongoing plan administration. - There is no guarantee that annuity rates will improve in the future. They could be lower when the individual decides to purchase their annuity than the current rates. The pension may be lower than if the individual bought a pension annuity.
- The value of the pension fund may go down as well as up. Additionally, the individual may not have a sufficient fund available to purchase an annuity equivalent to the amount out would have received at outset.
- Death benefits payable as a lump sum (under contracts being used to provide an income) are subject to tax at a special rate of 35%. In addition if the lump sum is not paid to the individual's spouse there might be additional further liability to Inheritance Tax.
- If they have not purchased an annuity by age 75, at that point the individual will have to purchase an annuity on the rates current at that time.
- The individual may feel that the prospect of future higher income does not compensate them for being able to enjoy a guaranteed and secure level of income today
