The following notes do NOT apply to people who are in “Final Salary” pension plans. The purpose of these notes is to try and explain some of the common options open to clients when they come to take their retirement benefits.
1. TAX FREE CASH
As a generalisation, if maximum income is required, it is usually better for people to take their maximum tax free cash from a money purchase pension plan and to take no tax free cash from a final salary pension fund. This does, however, depend upon individual circumstances (the plan may have guaranteed annuity rates for instance) and should be fully assessed in each case.
These notes refer just to money purchase pension plans. These fall into two legislation types:
2. SCHEME PENSIONS
These are pensions provided by the pension scheme itself (ie, a big final salary scheme) or by an insurance company nominated by the scheme administrator and are like a traditional pension annuity mentioned below.
3. LIFETIME ANNUITIES
With a traditional annuity the annuitant (person receiving the pension) gives cash to an insurance company in exchange for a guaranteed income for the rest of their lives. Once the annuitant dies, the income ceases and the insurance company keeps the balance of the initial investment.
The big problem with annuities is that the rates keep dropping. This is due in part to the poor investment returns forced on the providers but also to the increase in longevity.Over the last 25 years the percentage of the population aged 65 and over increased from 15 per cent in 1984 to 16 per cent in 2009, an increase of 1.7 million people. (National Office of Statistics June 2010)
This type of pension would be paid for the annuitant’s life alone. If the annuitant dies one month after starting the pension, the annuity ceases and the insurance company pockets the cash. On the other hand, if the annuitant lives to 125 the insurance company will keep paying.
4. INCOME DRAW DOWN (IDD) OR UNSECURED PENSION
As an alternative to using your accumulated pension fund to purchase a conventional annuity, it is possible to purchase an 'unsecured pension' (previously known as a 'draw down').This income can continue indefinately. As part of the investment choices within an IDD you can buy a short term (say 5 year) annuity. The maximum income is the equivalent of 100% of the Government Actuary department rates and there is no minimum requirement.
‘Flexible Drawdown’ which will allow higher levels of income (including one off withdrawals)
provided the you can satisfy a new test known as the ‘Minimum Income Requirement’ (MIR).
In essence, you will need to demonstrate that you have an ongoing guaranteed income of at least
the MIR before any Flexible Drawdown will be allowed.
The MIR has been set at £20,000 pa.
The MIR will consist of ‘relevant income’ which must be in payment at the time Flexible Drawdown is taken
and be guaranteed for life If you are already drawing your State Pension benefits, they can be included.
Unsecured pensions and maximum income will be reviewed every 3 years up to the anniversary of entering drawdown after the 75th birthday and annually thereafter.
Under "Capped Drawdown" initial income available from a draw down scheme is broadly based on an annuity that could otherwise be purchased. In other words, if the maximum annuity that could otherwise be purchased was, say £10,000 pa, then it would be possible to draw down from the fund any sum between £10,000 and £0 each year. The sum that is drawn down is taxed in the same way as an annuity, ie as income. The balance of the fund remains invested in a tax efficient environment and will ultimately be available (after tax @ 55%) for beneficiaries when the pensioner dies. Unlike a purchased annuity where the future income level is certain, there is no guarantee that the fund remaining will grow sufficiently in the future to maintain the level of income. A draw down scheme can be useful in certain circumstances. These might include an active interest by the member in continuing to manage their pension fund. Annuitants in ill health may prefer the ability to pass on remaining assets to their estate (after tax). Some people may prefer to take their tax free cash and no annuity now in the hope of receiving a higher pension when they are older, likewise some may take the opposite view and want the maximum annuity now when they are young enough to enjoy it. Naturally, the expenses associated with a draw down scheme will be higher (because of ongoing management and monitoring) and it is our view that under normal circumstances they are best suited to substantial pension funds (FSA state a minimum of £100k). On a like for like basis IDD will never match a guaranteed annuity as it cannot benefit from the mortality bonus. Where a pension is undertaken with a pension company the actuary of that company will assess the likely lifespan of the applicant. Life expectancy increases the older you get so at age 65 a male is expected to live to around 15 years. The actuary will then assume everyone lives for this period thus creating a rate which (after allowing for his profit) uses up the annuity purchase price over 15 years. This means of course that if you live for 20 years you are getting a much better deal than would be the case if you managed your own fund. On the other hand if you die young, clearly the IDD is better for your dependants.
5. TRIVIAL BENEFITS
If the value of all pension (or dependants) benefits is less than £18000 the benefits can be commuted for a lump sum. 25% of the lump sum will be tax free, 75% taxed as earned income.
6. PROTECTED RIGHTS
The Department of Work & Pensions (DWP) announced (December 2005) that protected rights funds can also choose from all the new alternative pension options including commutation for cash. From October 2008 protected rights funds can also be placed into SIPPs.
8. IMPAIRED LIFE/ENHANCED ANNUITIES
It is now possible (and common) to obtain underwritten annuities for individuals in ill health. One obvious form of enhanced annuity, which can sometimes pay dividends, is for cigarette smokers. In the same way that smokers can now pay 25% more for their life cover, smokers could obtain up to 15% to 20% better annuity rates. Whilst we would always look to underwriting any medical problems, severe ill health is sometimes better dealt with via a draw down or high level reversionary annuity.
9. PAYMENT FREQUENCY
It is usual for an annuity to be paid monthly in arrears. However, it is possible for it to be paid at other frequencies such as quarterly, half-yearly or annually, in advance or in arrears. There should be a reasonable return on leaving your fund with the annuity provider if it is paid, say, annually in arrears rather than monthly. Thus, if you felt it was more convenient to receive a single annual payment this could be achieved.
Clearly, everyone would like the maximum pension with minimum risk. Unfortunately, this utopia is unavailable. At the end of the day, the type of annuity received will be a compromise between security and immediate income requirements.
A pension fund of £100,000 (May 2012) would have purchased an annual pension of for a male and female both aged 65 as follows: Source:( FSA Moneymade Clear Website May 2012)
Whilst the above are historic values, the figures can be used to indicate the costs of each option. For instance, if inflation averages at 3% each year it will take the annual pension received from an RPI escalating pension around 12 years to exceed the level of the non escalating pension.
Using the same example for a male aged 65, the cumulative income received from the RPI pension does not exceed the total level pension received from a level pension until 22 years into retirement. Of course, the compounding effect of the escalating pension increases the amount received quite dramatically after these breakpoints.
Please note that whilst every effort is made to ensure that the information contained within this explanation is correct, these notes are by necessity brief and of a generalised nature. We would provide specific personalised advice prior to finalising any arrangement.