Drawdown Pension (AKA Capped Pension Income Drawdown and Flexi-Access Drawdown)
Pension Income Withdrawal provides a means of taking benefits from pension funds without committing to the purchase of an annuity immediately.
Under the option of 'Pension Income Withdrawal' you can choose to take up to 25% of your fund immediately as a tax-free cash lump sum. This option must be taken at outset; otherwise it will be lost.
Instead of buying an annuity with the remainder of the fund, the money remains invested, where it may benefit from investment performance in a tax-efficient environment. You may in this way defer taking an annuity until such time it is considered more appropriate. Before April 2006, an annuity had to be bought by age 75. This is no longer necessary, as changes mean that it is possible to remain in drawdown indefinitely.
In the emergency budget on 22 June 2010, transitional rules were put in place to raise the maximum age for taking benefits from 75 to 77. These rules stayed in force until 6 April 2011, when that maximum age was abolished altogether.
From April 2015, there are two types of Pension Income Withdrawals:
- Capped Pension Income Drawdown
- Flexi-Access Drawdown
Capped Pension Income Drawdown
Those who took out such a plan before April 2015 will be using Capped Pension Income Drawdown
Under the post 06/04/2006 rules, it is no longer mandatory to take withdrawals from your fund each year; but if you do, they can vary between minimum and maximum limits set at the time the arrangement is started. These limits are derived from tables published by Government Actuaries Department (GAD) and are based on the size of your fund, your age, sex and the current gilt yield.
In broad terms the maximum level of income is currently approximately equal to 150% of what could be provided by a conventional single life, level annuity. The minimum is currently 0% of the maximum (no income needs to be taken if it is not required). Income levels are revised by GAD every three years (yearly after age 75) and an appropriate adjustment to the level of income you receive may subsequently be necessary, where the level of income initially selected is either above the maximum or below the minimum revised GAD limits.
Also, the requirement to conduct a new review and set a new GAD maximum following a transfer of an existing drawdown plan has been abolished. The existing GAD limits can be retained, unless a new review is specifically requested.
However, please note that the GAD tables changed in 2011, so anybody taking pension fund withdrawal after age 85 will be treated as a 85 year old for the purpose of working out the GAD income rate.
For plans taken out after April 2015 (or existing plans that transfer into Flexi-Access Drawdown after that date), the major difference is that there upper limits to the amount that can be taken as taxable income. If required, the value of the remaining fund can be taken as income.
The Pension Commencement Lump Sum (PCLS) remains the same, which means that up to 25% of the fund can be withdrawn as a tax-free lump sum at the outset.
Money Purchase Annual Allowance
The ability to take the entirety of the remaining fund as cash does not mean that it is tax-free. All further income that is taken is taxable at your highest marginal rate, just as it was previously. Therefore, care should be taken when taking large amounts of income from a fund in any one tax year, or when taking the entire fund as cash, as a basic-rate taxpayer could end up paying higher-rate tax on the amount withdrawn, which could be far less tax-efficient than taking a regular income from the fund.
If you are considering using Flexi-Access Drawdown and making further pension contribution, you will be subject to the Money Purchase Annual Allowance (MPAA), which is currently £4,000.
This measure is used to prevent individuals taking large sums of money from a pension plans in order to fund further pension savings that would receive additional tax-relief. Effectively it limits the ability to continually recycle pension funds in order to generate additional tax relief.
Alternatively Secured Pensions (ASP)
Between 2006 and 2011, those who wished to remin in drawdown beyond age 75 would need to use an ASP. These were also similar to Unsecured Income and were available from age 75 when unsecured income had to stop. Originally formulated in order to provide pension benefits for those who object to annuities on religious grounds, it they used mainly by those who wish to avoid being forced to purchase an annuity at age 75. The key points relating to ASP were:
- The maximum income was 90% of the GAD factor applicable to a 75 year old.
- The minimum income was 55% of the GAD factor applicable to a 75 year old.
- The maximum income was reviewed annually using annuity rates from Financial Services Authority tables up to 60 days before the review date.
- No Tax-Free Lump Sum could be taken from an ASP. If no lump sum had been taken, this needed to be taken before entering into ASP.
- Any surplus funds on death could be passed to a charity, with no inheritance tax liability, or to another family member within the same pension scheme, but this attracted combined tax charges of up to 82% of the fund value. This made ASP unpopular, and they were not widely used.
Individuals who were using ASP were able to continue drawing income under the Capped Drawdown which are less rigid.
Investment Strategy and Management
The value of the fund(s), the level of income you withdraw each year and the final pension you purchase will all be dependent upon the careful management of the funds remaining invested. It is therefore essential that an investment strategy be adopted when starting this type of plan.
The level of income you choose to take will have implications for the performance of your invested fund(s), and will influence future possible levels of annuity you can buy. Whilst in the short term drawing the maximum possible income from the plan may be very attractive, this may have repercussions in the medium to long term as income from the plan is ultimately dependent on investment returns. For this reason, it is important that income requirements are balanced with a suitable investment strategy, which must be kept under regular review.
This calculation aims to show, in percentage terms, the investment returns required from an 'Drawdown Pension' arrangement to 'match' the income that could be paid by a conventional annuity, a given income stream selected or both. It takes account of plan charges and mortality costs (see below) and assumes that during the period of taking withdrawals, the underlying annuity interest rate and mortality basis will not change.
The effects of mortality upon 'Drawdown Pension' plans
One of the important elements determining the price of an annuity is the life expectancy of the annuitant when the annuity is started. Some annuitants will live longer than others and receive more in payments. Others will not even get their money back. This 'cross subsidy' can mean that the person who survives longer than average receives a very high return from the funds invested. This effect is known as the 'mortality drag'.
Within 'Drawdown Pension' plans, as income is drawn directly from the fund, there is no 'cross subsidy'. To compensate for this, additional investment returns are required. Where maximum withdrawals are being taken, it is estimated the additional investment return required to be about 1% per annum at age 60, increasing to 2% per annum at age 70.
What happens if you die whilst taking 'Drawdown Pension' ?
There are several options available to your nominated survivors or beneficiaries if you die while taking income withdrawals:
- On death before age 75 the fund can be passed on tax-free, whether as a lump sum or as a drawdown pension.
- If death occurs after age 75, if the fund is passed on as a lump sum, a tax charge of 45% will apply. However, if passed on as a drawdown, the beneficiary will pay tax on the income at their marginal rate.
In theory, these funds can be passed on indefinitely to future beneficiaries until the funds are exhausted.
- Income withdrawals are subject to income tax at your marginal rate just like earned income.
- When tax free cash is taken at outset and not utilised, it may be included in the value of your estate and therefore increase any potential inheritance tax charge.
Advantages of Drawdown Pension
- You are able to take the full tax-free lump sum entitlement at outset.
- The pension funds from which you take income withdrawals remain invested, therefore you retain control of your investment portfolio and potentially benefit from the growth provided by the investments selected.
- It gives the flexibility to either phase and/or defer annuity purchase indefinitely.
- Income may be varied, between set limits, to suit your personal circumstances.
- The facility to vary income levels may provide scope to mitigate your personal liability to income tax in certain years.
- The value of death benefits may be more attractive than annuity purchase.
Disadvantages of Pension Fund Withdrawal
- Future investment returns are not guaranteed and the value of the pension fund may fall. This may therefore result in a lower total income than if an annuity was purchased at outset.
- Annuity rates may be even lower in the future. This posed real issues when there was compulsion to purchase an annuity at age 75, but there is now the option to postpone this indefinitely.
- High withdrawals of income may not be sustainable during the income withdrawal period and may also reduce the amount of any potential annuity.
- The higher the level of income withdrawal chosen, the less that may be available to provide for dependants, particularly when the original fund is small and/or investment returns are poor.
- Increased flexibility brings increased administration costs. Charges are likely to be higher than those relating to the purchase of a conventional annuity and may increase in the future.
- For those who used Capped Drawdown, it is possible that the level of income selected at outset may need to be decreased or increased to comply with new limits arising from the three-year review.
For whom might Pension Fund Withdrawal be a suitable option ?
- For those who need the maximum tax free cash but do not require all the income that an annuity would provide.
- For those who are not entirely dependent on the income from the pension plan and can therefore afford to see fluctuations in its level.
- For those who understand the degree of risk involved and can afford to take such risks because, for example, they have substantial investments outside the pension plan.
- For those who are not married, given that the death benefits compare favourably to annuity purchase, where survivor pensions for anyone other than a spouse (or civil partner) may be difficult to arrange.
- For those who are suffering ill health, although careful comparison should be made with any available impaired life annuity.
- For those who do not wish to be 'locked' into buying additional benefits that are not required. For example, some pension schemes require a widow(er) pension to be purchased, which will be of no benefit if there is no spouse, or the spouse is in poor health.
Occupational Pension Fund Withdrawal
Occupational Drawdown was an alternative to Personal Pension Drawdown particularly for those who had failed the 'maximum transfer test', or were are entitled to more than 25% tax-free cash under the old Occupational Pension scheme rules, which has always been the limit on a Personal Pension Income Drawdown plan.
Under the new pension rules, these type of arrangements are likely to dwindle away, due to the fact that there is now one common set of rules applicable to all pension arrangements.
NOTE: This document is intended to provide a brief overview of the subject. It should not be read as a recommendation to use any particular product, as it does not take into account individual circumstances and attitudes.