The new name for income drawdown is Unsecured Pension (USP). These replaced the former when the rules for pensions simplification came into being in April 2006. An USP allows you to make income withdrawals from your pension pot until age 75 instead of you buying an annuity. After the age of 75 you either have to buy an annuity or transfer your fund to an Alternatively Secured Pension (ASP).
USP has many advantages compared to an annuity purchase. You have income flexibility, and you can vary the amount of income taken each year between the minimum and maximum limits. You also have control over the investment strategy. If the drawdown is set up through a Self Invested Personal Pension (SIPP) there is a wide range of investment options available.
You also have a choice of death benefits, unlike annuities where the only death benefits are available from the joint life annuity option, drawdown offers a choice of death benefits.
There are some disadvantages to USP. When you purchase an annuity, albeit at the best annuity rates, you give up the control of your pension fund in return for a guaranteed income. With USP you maintain control of the pension fund but your ongoing income will not be guaranteed and so it is a much riskier option than buying an annuity.
There are quite a number of risks involved when deferring your annuity purchase by investing in an income drawdown arrangement, and understanding and knowing how to manage the risks you face is very important. We have an investment risk, where the value of your investments can go down as well as up. We have a mortality drag, which means if you defer buying an annuity you will miss out on the mortality cross subsidy that exists. You could also have a decrease in your annuity purchasing power, especially If annuity quotes fall and the value of your pension fund does not increase enough to compensate, and you could end up with an annuity purchased in later years providing less income compared to purchasing an annuity today.
There are also income limits to consider. The amount of income that can be paid from an USP is calculated by reference to tables produced by the Government Actuary’s Department (GAD). The maximum income payable in any one year is about the same as that from a single life pension annuity and there is no minimum income requirement. To make sure the income limits from drawdown are in line with annuities the limits are worked out by reference to current gilt yields. GAD produces a set of special tables regularly based on a range of interest rates.
There is a compulsory review of the arrangement every five years to ensure that the fund can sustain future income payments. At the review stage the minimum and maximum annual income limits are set for the next 5 years.
Rules about tax simplification introduced a new option whereby you may choose to secure part (or all) of your USP through the purchase of a short-term annuity contract. The term of that annuity contract cannot be over five years, and the annual amount payable is bound by the same rules as income withdrawal payments paid direct from the arrangement. The term of that annuity must not go beyond your 75th birthday. This short-term annuity option gives you the opportunity to reassess your pension needs periodically and to choose alternative types of annuities, so long as they secure you an income for life by age 75.
For many, the flexible death benefits are the most attractive feature of income drawdown, as the most negative part of a pension annuity is the absence of any lump death benefit. On death there are three options. There is a lump sum death benefit where a surviving spouse or dependant may take the remaining pension fund as a capital lump sum, less a 35% tax charge. This lump sum payment will be free of IHT, providing the correct trust has been established. In addition, as alternatives, a surviving spouse or dependant may continue to make income withdrawals, or a single life annuity can be purchased.
An Alternatively Secured Pension (ASP) is a new option that allows you to avoid purchasing a pension annuity at the age of 75 by continuing with a limited form of income drawdown. Negatively, rule changes in December 2006 meant that the option to leave unused ASP funds to the family would attract an effective tax charge of something over 80%.
On your death, any remaining ASP funds have to be used to provide benefits for any surviving dependants. Your spouse or partner will be considered to be dependant along with children under the age of 23 who are in full time education. Any benefits paid to dependants must be in the form of income as there is no lump sum death benefit.
Phased drawdown (phased retirement) is another retirement option, and is a very tax efficient way to pay your retirement income. Your pension plan is set as a number of different segments and each year you convert a number of these into tax free cash and pension. Each vested segment will provide an element of tax-free cash (normally 25%), and an annuity purchase. The tax-free cash is normally added to the annuity and the two together provide retirement income for that year. As a fairly large part of the total annual income is made up of tax-free cash it is clearly very tax efficient as income tax is only applied to the annuity payment.
Moving on, in subsequent years further encashments are made in a similar fashion to provide more tax-free cash and income in addition to the pension annuities already in payment. Therefore there will be a number of different annuities and each one may be set up on a different basis.
On death of the policyholder before the age of 75, any unvested pensions segments will be paid out free of tax. In addition there might be continued benefits from the annuities in payment. For example, the balance of any guaranteed period and/or a spouse’s pension.
Making the decision between an annuity and income drawdown can be very difficult because there are many different factors. As you near retirement it is important to set out your objectives. As you do this you will realise that you have more than one objective and there is no one single type of annuity or drawdown that will meet all of these objectives. Therefore it is best to seek out specialist advice to see how your objectives might be met best; which retirement options are most suitable for you.