Drawdown (Unsecured Pensions)
These are old rules superseded by new drawdown rules from April 2011
Under the option of Personal Pension Fund Withdrawal (drawdown) you can choose to immediately take a tax-free cash lump sum and then, instead of buying an annuity, leave the remainder of the fund in a tax-efficient environment.
An annual income (taxed as earned income) can be taken from the invested pension fund. This income may vary between limits, set at outset by the Government Actuary’s Department (GAD). The maximum limit is derived from tables published by GAD and is based on your fund size, age, sex and the current gilt yield. The minimum limit is nil and the maximum is 120% of the GAD figure. The limits are revised every three years.
Tax Free Cash
Most types of pension plan have the option of taking a tax-free cash lump sum before exchanging the residual fund for a series of payments. Ordinarily up to 25% of the fund may be taken as tax-free cash., Income
A pension can be taken each year between nil and 120% of the maximum GAD rate. This income is taxed as earned income under the PAYE system.
If you die whilst in a drawdown contract your nominated survivor has three different options open to them: –
- he or she can take the fund as a cash lump sum, free of Inheritance tax on death before your 75th birthday,(measures are being introduced to raise this to age 77) but the remaining fund will be used in the Inheritance Tax calculation should you die after age 75 (measures are being introduced to raise this to age 77) or
- he or she can buy an annuity with the fund.
- You are able to take all of your tax-free cash lump sum entitlement at outset.
- You do not receive a set income but are able to vary it to suit your personal circumstances, between set limits, to supplement other sources of income.
- You are able to mitigate your liability to personal income tax in certain years.
- You have the potential to benefit from good investment performance in a tax-efficient environment and to exercise control over your own investment portfolio.
- It provides improved death benefits options compared with other retirement products
- High income withdrawals may not be sustainable during the deferral period
- 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 when the annuity is eventually purchased and could also affect the long term financial security of your spouse.
- The investment returns may be less than those shown in the illustrations.
- Annuity rates may be at a worse level when annuity purchase takes place. Although annuity rates generally increase with age, they have fallen dramatically during the past 15 years. This trend may continue.
- A careful investment portfolio needs to be constructed which will involve some investment risk. This means the fund value could fall which could affect your future income levels.
- Withdrawing too much income in early years may have an adverse effect on preserving your pension purchasing power or preserving the capital value of your fund.
- Increased flexibility brings increased costs and the need to review arrangements on an on-going basis.
- There is no guarantee that your future income will be as high as that offered by an annuity purchased today.
- You may feel the prospect of the future higher income does not compensate for the known income available from an annuity now and for the rest of your life.
- You may be prevented from withdrawing your chosen level of income due to the action of the GAD limits.
- The Financial Services Authority (FSA) has particular concerns in relation to mortality risk. If you purchase an annuity, you may benefit from a cross subsidy from those annuitants that die relatively early. This cross subsidy is not present with Drawdown and so to provide a comparable income, a higher investment return will be required. The impact of mortality can be expressed as an annual percentage rate by which the net investment performance of the remaining personal pension fund would have to exceed the interest rate implicit in an annuity in order to break even. This effect has become known as the ‘mortality drag’.
- The charges are explicit whereas under an annuity they are inherent in the annuity rate offered.
Inheritance Tax Issues
If it is unclear that there were sound retirement planning reasons for undertaking Pension Fund Withdrawal, and death occurs within two years, the use of the contract may be deemed as an attempt to circumvent the payment of inheritance tax (IHT). Furthermore, if you are in ill health and decrease the level of withdrawals with the intention of keeping the funds in your plan (thus outside of your estate), this may also be seen as a deliberate attempt to avoid IHT. In both cases, the Capital Taxes Office, could issue a claim and it is therefore vital that should your circumstances or personal health alter, that you seek professional advice on this very complex issue before reducing your withdrawals.
Product providers using a common prescribed basis illustrate critical yields. There are two types (A and B). Type A – the growth rate needed on the “drawdown” investment sufficient to provide and maintain an income equal to that obtainable under an equivalent immediate annuity. Type B – the growth rates necessary to provide and maintain a selected level of income.
Pension Fund Withdrawal can be suitable for a whole range of differing needs and financial situations, however it is generally accepted that the potential disadvantages and the inherent risks involved require the individual client to be a relatively sophisticated investor, who is capable of fully understanding the risks.
Given this the contract can be used as a tax planning tool, a means to accessing pension fund tax free cash without having to take the full taxable income and as a means for offering greater death benefit options.