Drawing your pension benefits
Drawing your Pension at retirement is perhaps the most important financial decision of our life. It’s not just a matter of taking the pension offered to you by your scheme.
As retirement approaches you’ll have to make some very important decisions regarding your financial situation that will have serious implications on your retirement years. So it’s highly recommended you seek professional advice.
For most people, their main income will come from pension arrangements. There are two main types:
• Occupational Pension Scheme including SSASs (an arrangement set up by an employer)
• Individual Pension Plans including retirement annuities, personal pensions, SIPPs or Free Standing Additional Voluntary Contributions (FSAVCs).
In recent years, many employers have opted to contribute into Group Personal Pension plans for employees. These are not Occupational Schemes.
5 key questions you need to ask
1. Should I defer my pension?
2. Should I take the tax-free cash lump sum option or use the entire fund to provide a higher annual income?
3. Should I transfer my funds away from the current provider (known as Open Market Option)?
4. What sort of pension annuity should I purchase?
5. What are Unsecured Pensions including Income Drawdown schemes, Short Term Annuities and Phased Retirement arrangements and would I gain from having one?
You need to consider each question carefully in respect to your wants, needs and financial circumstances. You should also understand what each of your decisions involves.
Deferring Your Pension
Occupational Scheme rules vary and will need to be checked. If you have an individual personal pension and don’t need the income, the funds can continue to grow virtually tax-free. Prior to April 2006 you had to purchase an annuity before you were 75. Since then, it’s possible to hold assets in the pension without drawing them or buying an annuity, (i.e. a ‘secured pension’ or an ‘alternative secured pension’).
It’s important to make sure any individual personal pension is placed under trust – so the full fund can pass swiftly and tax-free to your beneficiaries, should you die before age 75 without drawing your benefits. With an Occupational Scheme the ‘expression of wishes’ form nominates your beneficiaries, although ultimately it’s up to the Trustees. You should review this form regularly.
The Tax-free cash sum
Most pensions (including contracted-out pensions) will normally allow you to take a proportion of your pension fund as a cash sum, usually a minimum of 25% of the total value, which is paid free of tax. If you used this to buy a pension annuity, the income would be liable to tax. Therefore, it can be to your advantage to take the maximum cash sum and invest it elsewhere, if necessary, for income.
With certain occupational pension schemes – those that guarantee you a pension as a proportion of your final salary – it may not always be advantageous to take the cash. It is important to seek professional advice on what is best for your individual circumstances.
The open market option
After taking any tax-free cash sum, decisions have to be made if you also wish to take an income.
If you have an individual personal pension, you can arrange this with your current pension company or transfer the funds to another authorised provider who may offer a better deal. This is a very important option which you should consider carefully.
Purchasing an annuity is a commitment from the provider to pay an income on an agreed basis to you for the rest of your life. Once purchased you can’t exchange or return it, so it’s vital you get the most competitive terms. These vary enormously from company to company. We can shop around on your behalf and may be able to improve your pension significantly. However, it’s important to note that moving funds to a new provider may incur a transfer penalty and this will affect the decision.
Types of pension annuity
Conventional
When using your pension fund to purchase an annuity you have a number of options. Each can have a considerable impact on the initial level of income available to you. Most options are common to all plans, however a limited number of providers offer specially enhanced rates for people who smoke, are overweight or have certain medical conditions e.g. high blood pressure. We’ll discuss these with you in more detail but the major options common to all plans will be:
• The frequency of your income payments.
• The period for which your income payments will be guaranteed should you die within that period. Typical guarantee periods will be five or ten years. This is a useful option for those with dependants or people in poor health.
• The possibility to have a value protected annuity which guarantees at least a return of the balance of the purchase price having taken into account the gross annuity payments already made, in the event of early death. However, the return is restricted if the value protection continues beyond age 75.
• Whether your pension should be level for life or increase by a fixed percentage (or the Retail Prices Index) each year. If you elect for increases in your pension you should be aware that it may take up to fifteen years to outweigh the lower initial income which you’ll receive.
• Whether to include a spouse’s pension to come into payment on your death and if so at what level. Once again this will reduce your initial pension
Your personal pensions illustration shows the effects of some of the above options.
Investment Linked or With Profits
similar to conventional annuities, but instalments are not guaranteed. The pension fund is invested by the insurance company with the object of allowing you to share in the investment return of the Fund. As long as investment returns are favourable, you can expect some increase in your pension annuity. However, as with any investment-based contract, returns can go down as well as up, meaning your pension could also go down as well as up.
A With Profits annuity aims to achieve sustainable growth through prudent investment in a mixed portfolio of assets, while smoothing out the volatility of fluctuating investment returns.
A Unit-Linked annuity directly relates your pension to a portfolio of selected investments. Depending upon the Funds chosen, your annuity is likely to be more volatile than a With Profits scheme.
Charges are likely to be higher with both of these options than a conventional annuity because they are more complex. The underlying investment is expected to grow over the long-term, but may fall in the short-term. The initial income received from a with profits or unit-linked annuity may consequently be lower than from a conventional annuity. For both unit-linked and with profit annuities, the higher assumed growth of the fund is offset by a greater level of investment risk than a conventional annuity.
Unsecured pension options
An annuity will provide you with a guaranteed lifetime income. However, you may find yourself locked into an annuity when rates were particularly low or you may have purchased a spouse’s pension that’s not subsequently required.
Being locked into a pension at a fixed rate can be overcome to some extent by linking your annuity to the With Profits or Unit Linked funds of your chosen annuity provider. Income will however fluctuate with fund performance and could fall as well as rise.
This is also true of Unsecured Pension options, but with extra risk comes real flexibility. Below you can find the key features of the main options, though these plans are currently only available through certain providers and you may need to transfer your existing funds. This market is rapidly evolving and there may be other unsecured pension options available to you.
Income Drawdown Plans
For the last few years it’s been possible to take your benefits as withdrawals directly from your pension fund by using an Income Drawdown option rather than purchasing a lifetime annuity. This option is particularly attractive as it gives flexibility for future income levels whilst enabling the tax-free cash sum to be taken in full. You can usually take up to 25% of the value of the fund as a tax-free lump sum, while income is provided from the remaining fund – however since April 2006, it’s no longer compulsory to also draw an income.
The maximum level of income, often referred to as an ‘unsecured pension’, is determined by the Government and you may draw any level of income up to this maximum level or defer taking an income for as long as required. The maximum levels are reviewed every five years, but you may vary your income at any time to suit your needs.
The higher the income taken, the greater the investment growth needed on the investment fund to maintain that income. This in turn requires a higher risk investment strategy, particularly using equities. If only a modest income is drawn initially, there’s a greater chance of capital growth and improved future income. The fund remaining on death can be paid out as an income for a survivor or as a lump sum but would be taxed at 35%.
At age 75, Income Drawdown ends and either a lifetime annuity is purchased or the funds moved to another form of drawdown known as an ‘alternative secured pension’. Full details of this option will be given at the time.
Short Term Annuities
Recent changes in legislation now allow individuals to purchase short-term annuities rather than those payable throughout life. For a single payment from the fund, after drawing any tax free cash sum from that portion, an insurance company will pay a guaranteed income over a fixed period (e.g. five years), while the balance of the fund remains invested for future flexibility and to replace the funds used to purchase the short term annuity.
At the end of the term, you can purchase a further short-term annuity provided it doesn’t expire after age 75, or any of the options for drawing pension can be taken as set out in this document.
Delaying purchasing a lifetime annuity can result in the value of your fund falling, as could future annuity rates. This could mean overall income payable during your lifetime or the joint lifetime of you and your spouse could be higher or lower than if an annuity were purchased immediately.
Phased Retirement
this type of plan is appropriate if you do not require the tax-free cash as a lump sum but are happy for this to go towards your regular income withdrawals.
The arrangement is divided into a number of sub-policies. Sufficient numbers of these sub-policies are ‘cashed in’ each year to produce the required income – partly out of tax-free cash and partly by annuity purchase or as a ‘secured income’.
Until the sub-policy is cashed in, the fund continues to grow tax-free and can remain outside your estate for inheritance tax purposes. You can purchase an annuity in whole or part at any time, if rates are favourable, or you draw an ‘unsecured income’. The fund remaining on death before age 75 is paid free of income tax, whereas it would be taxed at 35% under an Income Drawdown Plan.
Similar risks apply for the Income Drawdown Plan and Short Term Annuity, as the overall income could be higher or lower than under the annuity purchase route.
Phased Drawdown
This is a combination of a Phased Retirement and an Income Drawdown Plan. The pension funds are initially paid into a Phased Retirement Plan and sufficient amounts are then transferred each year to an Income Drawdown Plan to meet your target income. This leaves the majority of the funds remaining in the Phased plan, offering the most favourable tax treatment of death benefits.
Phased Retirement and Phased Drawdown Plans are not suitable for those requiring an immediate tax-free cash sum.
If you wish to have indication of how pension annuity figures change according to the options chosen. Simply Click the 'Download Document' link below.
Download Document