Drawdown and how it works
Regulations introduced in the Finance Act effective from 6 April 2011 changes the amount that can be drawn from an income drawdown plan. With the removal of the requirement to purchase an annuity at the age of 75, an individual will be able to continue in drawdown for their lifetime. This means it is possible to defer purchasing a pension annuity until the member is older
rates and the pension fund value could be higher.
Income drawdown is higher risk than a pension annuity and there is no requirement to take an income. Since April 2015 there is now no limit to the amount of income that can be taken from new plans called flexi-access drawdown. After taking your tax free lump sum you can take the full fund from the pension and this is treated as income taxed at your marginal rate.
There are two types of drawdown pension known as Flexi-access Drawdown and Capped Drawdown. For existing capped drawdown plans there remains restrictions on the amounts that can be taken as income and the maximum income that can be drawn from 27 March 2014 is 150% of a comparable annuity for a single person at a given age as determined by the Governments Actuaries Department (GAD) and results shown in the drawdown rates.
Capped drawdown has an advantage for those that remain under these rules as it allows you to contribute £40,000 a year to your pension and receive tax relief whereas flexi-access drawdown is restricted to £10,000 a year.
An alternative route could be to use phased
retirement where only part of their fund is used for
a compulsory purchase annuity. Both flexi-access drawdown and phased retirement will require an initial fund value of more than £30,000 before tax free cash is taken and have alternative pension arrangements. Significant advantages of flexi-access drawdown are the ability to take the tax free lump sum of 25% while leaving the pension fund invested and improved death benefits for a spouse or beneficiaries.
Flexi-access drawdown is more
suitable to individuals that continue to have other income
sources to rely on such as working part-time or income
from 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. 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.
Since the pension simplification changes from 6 April 2006, unsecured income was the official term for Pension Drawdown which is also know as "income drawdown" or "pension fund withdrawal".
The term "unsecured income" refers to a pension arrangement whereby the underlying assets remain within investments that can go up and down in value and is therefore not secure as the level of payments cannot be guaranteed for life. A "secure income" refers to a pension arrangement whereby there is a guarantee or security of payment for life, such as a final salary pension scheme or pension
annuity. An unsecured pension fund is the fund of tax relieved pension savings which allows an individual the facility for income withdrawal.
Until 6 April 2011 it was only possible to have an unsecured pension fund up to age 75. For those individuals that did not wish to purchase pension annuities at age 75, an alternatively secured pension fund permitted the extension for income withdrawal subject to greater restrictions although both Unsecured Pension (USP) and alternatively secured pension (ASP) have now been replaced by drawdown pension for anyone retiring from age 55.
The USP structure for income withdrawal was introduced
in the Finance Act 2004 and implemented through The Registered Pensions Scheme (Relevant Annuities) Regulations 2006 effective from 6 April 2006. The regulations require that the "annual amount" of a "relevant annuity" is to be calculated using HM Revenue & Customs (HMRC) tables prepared by the Governments Actuaries Department (GAD).
Originally unsecured income was known as pension drawdown but in 1997
the Personal Investment Authority (PIA)
changed its name to pension fund withdrawal. The concept was
introduced by the Inland Revenue as an alternative to pension annuities. 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. Now the Finance Act has re-introduced the original term of Pension Drawdown.
Although 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 an pension drawdown plan.
Further changes in the 2014 Budget allow the amount to be taken from drawdown to be 150% of GAD and the minimum secured income for flexible drawdown has been reduced to £12,000.
An individual can enter into an income drawdown plan from the age of 55 since 2010 as part of the Government policy to encourage greater participation in the labour market by older workers. Previous to A-Day pension annuities had to be purchased at the age 75. This requirement is no longer necessary as the removal of the age 75 rule means individuals can continue in drawdown and purchase an annuity with all or part of their pension fund without any age restrictions.
Tax free lump sum
For many pension scheme members the primary advantage of income drawdown is the opportunity to a tax
free lump sum (or also known as pension commencent lump sum) of up to 25% from their pension fund value immediately without the need to purchase a pension annuity. If the member does not take the tax free lump sum at the outset, the right to take a cash lump sum is lost thereafter. However, if the drawdown is invested through a self invested pension plan (SIPP) it is possible to segment the plan and therefore allows the individual to crystalise part of their fund. This would allow some segments to continue and a tax free lump sum can be taken from these segments at a later date.
This means a cash lump sum is available from the age of 55 and post A-Day it is possible to leave the remaining fund to benefit from investment performance in a tax-efficient environment without the requirement to drawdown an income. Before 6 April 2006, the member would have been required to take a minimum income of 35% of a single life annuity as determined by GAD.
From April 2015 there are now no restrictions to the amount of income that can be taken from flexi-access drawdown. It is possible to take the full fund from the pension as income taxable at your marginal rate and this may mean you need to spread the income over two or more tax years to reduce the impact of tax.
For those that remain in capped drawdown the old rules remain and
changes from 27 March 2014 allow people to withdraw a maximum income of 150% based on the GAD tables or a minimum representing 0% of this maximum. The income draw amount can be changed at any time depending on the circumstances of the member and the terms of the provider.
With the introduction of pension simplification from 6 April 2006 the maximum income was from 0% to 120% based on the GAD tables and previous to A-Day
the withdrawal amounts from income drawdown was a maximum income of 100% of a single life annuity
and the minimum was 35% of the maximum.
The GAD tables apply only to capped drawdown and measure the annual amount of lifetime annuity income pension drawdown fund could generate for a member being males, females or dependants, at the point of calculation and also apply to any contracted-out protected rights portion of the pension fund.
These tables are based on a standard annuity, single life, level with no guarantee period and contain rates covering an age range from 0 to 85 years old. This range is required as a child dependant could have a dependant's unsecured pension fund from birth and for individuals 85 years and older the GAD rate is fixed.
Before making a decision regarding pension drawdown learn more about annuities, compare annuity rates, and secure a personalised annuity quote offering guaranteed rates.
Every three years the income levels of the tables are reviewed by GAD and adjustments made based on long-dated gilt yields which could mean 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
Insurance companies offering annuities use actuarial data
to anticipate broadly how long a group of people will live on average. This means they are better placed to manage the risk of a group of individual funds running out during their lifetime than an individual could manage themselves.
of this group "pooling" is that some members in the group will die earlier than expected and the insurance company can therefore continue to pay those that live longer, resulting in a mortality cross-subsidy. Unsecured income from an income drawdown plan does not participate in this mortality cross-subsidy as income is drawn directly from the individual investment.
To compensate for losing the cross-subsidy if a member delays buying a pension annuity, the underlying investments within an income drawdown plan need to grow at an extra amount and mortality drag describes this effect. This Mortality drag is also referred to as the gap between the available annuity rates at a given age and the conventional interest rate.
Mortality drag increases with the member's age at annuity purchase as the benefits of mortality cross-subsidy increase. It is estimated that an additional investment return required above gilt yields for a male would be 1% per annum at aged 60, 2% per annum at age 70 and 3% per annum at the age of 75. If the investment return is less than these levels, it would not be worthwhile delaying an annuity purchase.
Costs and risks
Income drawdown plans represent a higher risk to the individual than a secured income arrangement such as a pension annuity as the underlying assets of the fund are usually invested in the stock market. To ensure the pension fund does not run out of money, the member will require investment advice and regular reviews.
Over the life of the an income drawdown arrangement these costs have been estimated at approximately 5% of the initial fund value although large funds will have a lower percentage as there are more assets to off-set fixed costs.
The cost of managing a pension annuity contract is much lower as the resources of a group of individuals are pooled and there is no need to review on an individual basis. The insurance company must ensure there are sufficient reserves to meet the liabilities, however, this cost is spread across the entire group of individuals.
Where drawdown is for a short period of time to take advantage of pension rules from April 2015, it is possible to set-up a plan in a cash or sterling liquidity fund with lower costs. This could include a one-off drawdown fee of £100-£200, an ongoing plan charge for administration of 0.25% and fund charge of 0.15%.
In addition both annuities and income drawdown have a one-off advice and administration charge to establish the plan. For smaller fund with one provider of say £50,000 this could be about 1% to 1.5% of the fund value after tax free cash is taken. For larger funds of £150,000 this could be under 1% depending on the level of work involved and number of providers.
Due to the higher costs associated with income drawdown, fund sizes should be at least £30,000 after taking a tax free lump sum. As the growth of the pension fund depends on investment performance, it is important to have alternative retirement income or savings in addition to an income drawdown plan in the event of poor investment performance.
A significant reason for considering income drawdown rather than secured income such as pension annuities are the associated death benefits. If the member dies while invested through an income drawdown
plan, the remaining crysatallised pension funds in drawdown can be pass to a spouse tax-fee provided that it is used to provide a dependant's pension. A spouse has a number of options as follows:
||Continue within income drawdown:
||Take the fund as a lump sum and pay a 55% tax charge:
||Buy a pension annuity with the remaining fund.
If the spouse continues within income drawdown they can do so for the whole of their lifetime. Any income received from this arrangement would be subject to income tax. By taking the fund as a lump sum the spouse must pay a 55% tax charge. Where the benefits are uncrystallised and death occurs before the age of 75 the pension fund will remain tax-free. In general the residual fund is paid free from Inheritance Tax (IHT) although HMRC may apply this tax.
The 55% recovery charge applies to death after 6 April 2011 and for those individuals in pension drawdown before this date this represents a significant increase from their previous 35% rate and makes phased drawdown more attractive where an individual does not require the maximum income and can leave some segments uncrystalised and therefore not subject to the 55% tax charge on death. For those individuals that were in ASP drawdown represented a reduction in tax on death from 82% down to 55% and they benefit from the changes from 6 April 2011.
Alternatively secured pensions
The alternatively secured pension (ASP) and the concept of Unsecured Pension (USP) no longer apply and have been replaced by drawdown pensions for anyone retiring from age 55 from April 2011. For more information about how alternatively secured pensions (ASP)worked, click here.
About Sharing Pensions
Sharingpensions.co.uk was created by its founder Colin Thorburn in 2001 to provide a free pensions and annuity resource to hundreds of thousands of people at retirement making their decision making easier and to select the best options.
Colin Thorburn has nineteen years experience in pensions and annuities, is an individual authorised by the Financial Conduct Authority and business is submitted through Blackstone Moregate Ltd which is authorised and regulated by the FCA (no. 459051).