OPTIONS ON TAKING BENEFITS FROM YOUR PENSION PLAN

When you come to start drawing your benefits from your pension plan, a number of options can be available. Further details are provided on the pages headed Annuities, Phased Retirement And Drawdown under the Pensions button above, but the main points can be summarised as follows:-

Annuity

To provide a known, guaranteed (taxable) income for life, normally after you have taken the tax free cash sum. Generally, you should not accept the annuity offered by the provider of the pension plan until you have considered whether another insurance company can provide better terms - this is known as the open market option. 

In addition, it is worthwhile shopping around if you are a smoker or have, or have had, any medical conditions, as enhanced annuities can then often be provided, improving your pension income at no extra cost.

Phased Retirement

Instead of buying an annuity, phased retirement plans split your pension fund into a number of policies or "slices", and each year the benefits from each slice of the fund are taken in the form of a tax free cash sum and a (taxable) annuity or a drawdown. Together, these form part of your "income" for that year. Further "slices" are encashed each year in the same way to provide additional income, which should therefore increase each year.

This enables a flexible approach to income, whilst enabling you to retain some control of your pension fund with improved options on your death for your spouse and other beneficiaries.

Drawdown Plan

This type of plan provides much increased control and flexibility. After taking the tax free cash sum, your pension fund would remain invested in your pension plan and you make "withdrawals" from your fund (still taxable) within certain limits laid down by the Government Actuary Department.

The Chancellor announced in the 2014 Budget that the limits on the amount of withdrawals you can take from your pension plan will be removed from April 2015 (although the sum above the tax free cash sum is still taxable).

This provides considerable flexibility on how you draw income, whilst improving the choices on leaving funds to your spouse and other beneficiaries on death.

Each of the above offer their own opportunities and risks, and further information can be provided by our guide "Pension Income In Retirement". Request a copy from us. 

The 2014 Budget introduced radical changes to pensions and thereby removed two of the main objections raised to saving in a pension plan - investors can take all of their pension fund in one go, and the tax that applies when pension funds are passed on to heirs is much improved.  The radical changes are designed to give pension savers more freedom and choice than currently.

The main choices as to how you take your pension benefits are summarised below. The guide is quite detailed since the choice is often a one-off decision, although a summary of the options is provided at outset.

If you have a defined contribution pension plan (ie not a final salary scheme) there are now many ways in which you can draw on your pension fund, and it is important that full advice is taken so that the right choice is made for your circumstances.

The main choices include the following:-

• Take the tax free cash sum only (25% of the fund value usually) and leave the remaining fund – it then remains invested until you determine the time when you wish to start drawing benefits.

• Take the whole of your pension pot as a cash sum – the first 25% being tax free with the remainder of the pot taxed as income at your marginal rate. This rate of income tax could be more than 20% as the taxable part of your fund would be treated as income and added to your other income for the tax year to determine the rate of tax applicable - it could therefore push you into the 40%/45% taxation bracket depending on your other income. It is clearly important that the right taxation advice is provided.

• Take the tax free cash sum (25% of the fund value usually) and use the balance of the fund to purchase a guaranteed taxable annuity payable for life. The amount you would receive would depend on certain factors such as your health and whether you smoke, and details can be provided.

• Take the tax free cash sum (25% of the fund value usually) and leave the balance of the fund invested, from which you can take withdrawals on a regular basis or on ad hoc (one-off) basis as and when required. Such withdrawals are still taxable. How long your fund would last would depend of course on the investment returns and the amounts you withdraw.

• Mixing and matching – taking some lump sum, some in a drawdown plan, some used to purchase a guaranteed annuity.

Other options are available, and not all of the above options will be available through your current plan.

So the options now available as to how you take your pension benefits have been increased considerably, and we consider these options in turn.

The usual rule was that “you can take one quarter of your pension fund as a tax free cash sum and the rest has to be taken a a taxable income”.  This is now not the case.

1) If you are over age 60, with total pension savings of £30,000 or less, you can take your entire pension as a “trivial commutation lump sum”.  Only one-quarter of the pension pot can be taken tax free, the remainder being taxed at your highest marginal rate of income tax.

2) Stranded pot rules: Small “stranded pension pots” of up to £10,000 can be taken as a lump sum by anyone aged 60 or over - a significant increase from the previous £2,000 limit. And the number of small stranded personal pension pots that can be taken as a lump sum in this way is increased from two to three. So, if you have up to three small pension pots of up to £10,000 each, you can take each one as a lump sum – again, only one-quarter of the value can be taken tax free, the remainder being taxed at your highest marginal rate of income tax.

3) The rules 1) and 2) above were further superseded from April 2015 to give flexible access to your pension plans from age 55.

If you are of pension age (55+) you will be able to draw as much (or as little) from your defined contribution pension pot as you choose at any time. You can even take the whole fund as a lump sum. One-quarter is still be tax free (if you have not already taken the cash sum). The balance is taxable as income in the year it's taken. So, if you are a basic rate 20% taxpayer, any income you draw from your pension will be added to other income you receive such as salary, and this could push you into the higher 40% or even the 45% tax bracket.

You can of course choose to take the pension out in stages to provide an ongoing or ad hoc income, and this should help you to manage your tax liability. Perhaps more importantly, it will give flexibility to providing an income stream for you – remember why you took out the pension plan in the first place.

The new rules will also apply to anyone currently in income drawdown plans, under which your pension fund remains invested and under your control, choosing how much income you take and where to invest. The difference to the current position is that the income limits will no longer apply from April 2015.

Income Tax On Pensions Payments

Remember that after taking a tax free cash sum of 25% of your fund, anything else you take is taxable. If you take the remainder of your fund in one go it is all taxable at income tax rates. It is added to your other income in the tax year to determine how much income tax you will need to pay.

Let’s say you have income from other sources of £10,600 and a pension pot of £100,000 which you decide that you will take as one lump sum. £25,000 of the pension pot would be tax free, and £75,000 would be taxable. Based on current rates and reliefs, you would pay income tax at 20% on the first £31,785 and 40% on the balance. So, out of the £100,000 you would receive £76,357 only. There may be further complications:-

• Taxable pension pots are taxed under the PAYE scheme. It may be therefore that some of the pension pot is taxed approximately and that you will need to repay or reclaim the correct taxation from the Revenue through self assessment returns.
• This will be particularly so for larger pension pots if you decide to take it all together. If the taxable part, when added to your other income for the tax year, exceeds £100,000, then you start to lose your personal allowance, increasing the tax burden.

Care – take advice and plan!

The big winner here is the Chancellor who is expecting to boost the Treasury coffers by nearly £4 billion between 2015 and 2020!

A conventional annuity provides a guaranteed income for life and, if you decided, for your spouse or dependants after your death. After taking any tax free cash sum, the whole pension fund is then used to pay for the annuity. You have to make certain decisions at outset, that is when you use your pension fund to buy an annuity, as the decision cannot be changed later. Such decisions include whether:-

• you want an annuity which is paid for your lifetime only or one which is lower but continues on your death for your spouse or dependant, and if so at what rate.
• you want the annuity to be level (ie does not increase in payment) or one which starts lower and increases each year by a fixed percentage or by inflation.
• you want the annuity to be guaranteed for a minimum term to provide some protection (for example, an annuity paid for your lifetime but guaranteed to be paid for a minimum term for your beneficiaries – such terms were previously limited to 10 years but now you can have guarantees up to 30 years+).

Once you have made the decision as to how your pension is to be paid, it cannot be changed at a later date.

Although conventional annuities provide a secure, known income for life, they are inflexible, and the pension fund is lost forever. Decisions have to be made at one point in time relating to dependants’ benefits, whether pensions should increase in payment or not, and so on. Once a decision is made as to how pension benefits are taken, it cannot be changed at a later date. The whole pension fund (after allowing for any tax free cash sum) is used to buy the annuity – a large portion can be lost to the Insurer if you and your dependants live for only a short time after retirement. Falling annuity rates have meant that pension funds are buying much less income than in the past.

There are other aspects of annuities before moving on to other options:

The Open Market Option

Too many people take the annuity offered by the provider of the pension plan.  Although you have built up your pension fund with one or a few providers, even if you have been happy with their performance there is no need to accept the annuities offered by the same provider. You will ordinarily have the option of placing your pension fund with another insurer by using the open market option, and this could increase the amount of annuity you receive considerably. This is important yet not everyone takes advantage:-

Different insurers offer different rates when converting your pension fund (after you have taken the tax free cash sum) into an annuity for life. It is rare for your existing insurer to offer the best rates available in the market.

Rates of annuity can be improved further by considering your lifestyle (whether you smoke, drink alcohol, have high blood pressure/cholesterol, and so on, or whether you have other medical conditions now or in the past (heart attacks, strokes, cancer, diabetes and many others).

If the annuity option is right for you then do check the market for the best rates available.

Unitised Annuities

An alternative to a conventional annuity is the unit-linked or with profits annuity.

Under a unitised annuity, your pension fund is invested in equities and other assets to produce income relating to the performance of the underlying assets. Whilst this creates a higher risk, the idea is that over the longer term equities in particular generally outperform gilts or government bonds (these being used to determine current annuity rates for conventional annuities) so unitised annuities should provide a good hedge against falling annuity rates and inflation. A with profits annuity is similar but invests in the with profits fund of the insurer to provide a lower risk version, although will still incorporate risk to the amount of future income that can be provided.

The basis of your pension income (eg spouse’s pension or the rate of increases to pensions in payment) is still determined at outset and cannot be changed later, but you future income payments depend on the performance of the fund. As unit values are expected to rise in the future (they can of course fall also), the initial amount of the annuity is lower than for a conventional annuity although you can choose to boost your early payments by anticipating future growth in unit values – say at 5% a year. Making such a choice at outset (which you cannot change later) will mean that increases in your annuity are less likely in the future and your pension annuity will fall below the initial level if the rate of growth in unit values is lower than the chosen anticipated growth rate – the amount of income is reviewed annually.

Conventional and Unitised Annuities – A Summary

 There are further options when considering annuities:-

 Temporary Annuities With Guaranteed Maturity Amounts

 Annuities offer guarantees but with no flexibility with regard to your fund and little control. Drawdown plans (see later) increase the control and flexibility, but with increased risk. This has led to the development of a further way of providing benefits. Your pension fund would be passed to an insurer who would provide the tax free cash sum as usual. The remaining fund would be used to provide a temporary annuity – a fixed annuity which will be paid for a specified term – for example 5 years.

 The attraction is that at the end of the term a guaranteed maturity amount is then available to purchase a further temporary annuity or a lifetime annuity. The option enables you to select a known income level (within limits) for a limited period in the knowledge that the guaranteed maturity amount available at the end of the initial term will then be available to provide future income – keeping your options open as your circumstances change.

 If you die during the term of the temporary annuity, various options can be included:-

 dependant’s income: a selected proportion of your own income can continue to be paid to your dependant for the remainder of the term. The same percentage of the guaranteed maturity amount can then be paid at the end of the term for the dependant to use to provide future pension income through an annuity or other appropriate pension income plan.

• value protection can be included should you and your dependant die during the temporary annuity period so that the initial fund (after tax free cash sum taken) less the gross income payments paid out can be paid as a lump sum to your estate or beneficiaries (tax free if you are under age 75, taxable at the beneficiary’s marginal rate of income tax if you are over age 75).

Combined Annuity and Drawdown Options

These plans are designed to combine the attractions of the annuity and the drawdown (see below) routes. They aim to provide the security of a known income level whilst enabling some flexibility of retaining control of your pension fund.

(a) Guaranteed Income Plans

Such plans work as follows:-

• Your pension fund remains invested.
• The provider will provide a level of income that they can guarantee.
• The income level is then reassessed regularly taking account of investment performance.
• If the value has increased then normally the income level can be increased, if it is lower then the guarantee ensures that the income level is maintained.
• The income level becomes locked in at the highest level – the guarantee is reset at each review.
• The income guarantee is often described as an “insurance” as it provides an underpin of the income level.

The main advantages are:

• Guaranteed income for a period or for life.
• Some plans may offer a guaranteed minimum fund at the end of the period.
• Death benefits are available for beneficiaries in respect of the remaining fund.

The main disadvantages are:-

• Less flexibility than for a drawdown plan.
• Less fund choice – the providers will limit how you can invest your fund since they have to provide the guaranteed income.
• Increased charges – the costs of the “insurance” have to be met.

(b) A Mix and Match Plan

Your pension fund is effectively divided into two parts:-

(i)  One part provides a guaranteed annuity based on the options selected at outset (ie inclusion of a dependant’s annuity, increases in payment, minimum guaranteed periods, etc).

(ii) The second part of your fund is used for drawdown (see later).

This type of plan tries to combine the attractions of a known guaranteed income for life with the flexibilities available from a drawdown plan.

The plan can be particularly useful if you wish to secure an absolute minimum level of guaranteed income (for example to meet ordinary living expenses) whilst wanting full flexibility and control of your pension fund above this minimum level.

------------------------------------------------------------------------------------------------
 Drawdown

------------------------------------------------------------------------------------------------

Under this option, the funds under your pension plans are transferred to a drawdown plan, from which you would take your tax free cash sum of 25% of the value. The remaining fund would remain in the pension drawdown plan and you can draw on this at any time in the future (all such withdrawals would be taxable).

This route enables you to access the tax free cash sum now, whilst enabling you to decide at a future date how you wish to access the remaining funds, for example:-

• To take the remainder as a cash sum (taxable as you would already have received your tax free cash sum)
• To draw a regular amount from the fund (still taxable)
• To draw irregular amounts from the fund – that is, amounts as you require funds (still taxable)
• To use the remaining funds to purchase an annuity (taxable)

The only limit to the amount you can draw from your pension fund is the amount actually in it of course.

The main advantages and disadvantages of a drawdown plan are:-

1) You retain control of your pension fund, with full access to the funds as you require.

2) You can decide how you wish to access your pension fund.

3) The position on death is favourable:-

On death before age 75: pension fund remaining can be taken by beneficiaries tax free as a lump sum or as income.

On death after age 75: pension fund remaining can be taken by beneficiaries as a lump sum or as an income (subject to the beneficiary’s rate of income tax). 

Beneficiaries can use your pension fund on death to provide benefits and then pass these on to their beneficiaries and so on – cascading wealth down the generations.

4) However, if you draw too much from your plan, the fund is likely to be depleted quickly.

5) Under a drawdown plan, decisions have to be made as to how the remaining funds are invested – into which funds. There is a risk that values can fall. If you leave the funds invested in a very low risk fund such as a cash fund, the plan value will fall as you draw down from it. If you set the risk level too high, the plan value is likely to be very volatile. Careful consideration is required.

6) Annuities provide a known guaranteed income without risk but without flexibility. Drawdown plans provide flexibility but with increased risk.

The Investment Of The Funds That Remain In Drawdown

If you decide on drawdown, how you invest the funds is a very important, not just initially but on an ongoing basis, since pension plans can typically be invested over a long term.

In determining the investment of your funds, we:-

1) Try to determine the level of risk you are prepared and able to take.

2) This level of risk goes some way to determine the allocation of asset classes to fit that level of risk. This in my view is more important than the individual fund selection.

3) Suggest short term adjustments to this longer term model where we feel this is right in current circumstances.

4) Determine individual funds to fit into the asset classes.

5) Provide and discuss regular updates with suggested changes.

The above are discussed more fully in the enclosed “Developing An Investment Portfolio” which we should discuss.

Taking Benefits From A Drawdown Plan - Summary

Taking Benefits From Your Pension Plan

• Benefits can be taken from the age of 55 onwards.
• 25% of the total fund can currently be taken as a tax free cash sum.
• The remaining fund can be drawn as regular income or as lump sums (ad hoc or otherwise) but will be subject to income tax at your highest marginal rate. Alternatively, you can use the fund to purchase an annuity if you so wish.

Death Before Drawing Benefits

If you die before drawing any benefits from your fund, the value of your fund will be paid to your estate or nominated beneficiaries, without taxation and outside of your estate for Inheritance Tax purposes.

Death After Drawing Benefit From The Plan

If you die after starting to draw benefits from the plan and before age 75, the fund value is available for your beneficiaries without taxation and outside of your estate for Inheritance Tax purposes. This can be paid as a lump sum or the beneficiaries can “take over” or inherit the pension plan and take tax free withdrawals as required.

If you die after starting to draw benefits from the plan and after age 75, the fund value is available for your beneficiaries although is taxable on the beneficiaries at their rate whether taken as a lump sum or as income.

If you have already purchased an annuity with the fund, the benefits on death would depend on the form of the annuity you selected (eg whether it included a spouse’s annuity on death).  

Brief Comparison: Annuities and Drawdown Plans

The drawdown process described can be “phased in”. Your pension fund is split into a number of policies or “slices”. Each year, a slice of the fund is “vested” – some of it is used to provide a tax free cash sum and the balance enters into drawdown (or could be used to buy an annuity). The tax free cash sum and the taxable income provide your withdrawals for that year. The remainder of the fund stays invested and each year a further slice is vested to provide a mix of tax free cash sum and taxable income and so on.

The current “annual allowance” (the maximum that could be invested into a pension plan in a year) is £40,000. If you take income from your pension pot (in addition to the tax free cash sum), your pension annual allowance will fall to £10,000.  This rule is effectively an anti-avoidance measure (for example to stop people having their salary paid into a pension and receiving 25% tax free with no NIC on the balance). It will not affect many people, and there are some exemptions:-

• if your pension pot is worth less than £10,000,
• if you use your fund to buy an annuity,
• if you are already in drawdown and your withdrawals after April 2015 remain within the drawdown limit.

The intention is that everyone should have free guidance on their retirement options, and this will be provided by organisations such as the The Pensions Advisory Service (TPAS) or the Money Advice Service (MAS).  It will be offered through web-based, phone-based or face-to-face channels, but will be guidance only rather than advice.

The new income flexibility will be available for defined benefit (final salary) pension scheme members, although to do so they will need to transfer to a “defined contribution pension” such as an income drawdown plan or SIPP. Because transferring from a final salary scheme can involve you in losing very valuable benefits, there is an insistence that you receive Independent Financial Advice first.

The earliest date you can take retirement benefits is set to become linked to the state pension age. As the state pension age increases to 67 between 2026 and 2028, the normal minimum pension age will also increase from 55 to 57. From then on it will remain 10 years below the state pension age. 

On death before age 75: pension fund remaining can be taken by beneficiaries tax free as a lump sum or as income.

On death after age 75: pension fund remaining can be taken by beneficiaries as a lump sum or as an income (subject to the beneficiary’s rate of income tax). For the 2015/16 year only, taking the fund as a lump sum will entail an income tax charge of 45% as an interim measure.

Beneficiaries can use your pension fund on death to provide benefits and then pass these on to their beneficiaries and so on – cascading wealth down the generations.

The Government has announced an overhaul of annuity rules to allow for more flexibility such as:-

• allow lifetime annuities to decrease in payment (useful for example for someone taking benefits before State Pension Age so that they can provide a higher income, reducing once the State Pension comes into payment).
• allow lump sums to be taken from (new) lifetime annuities.
• allow payments from new annuities to be paid to beneficiaries as a lump sum.
• Allow existing annuities to be “bought out” for a cash sum.

These are announcements only at the moment - there is likely to be considerable innovation in this area over the coming years.

No. Many pension plans will not be in a position to offer the new flexibility and you may need to transfer your pension plans to one that does, if you wish to.

The notion of retirement is changing – it is not just about your pension plans but should involve consideration of all of your assets and savings plans to arrive at the best outcome for you.

 Contact John Perry should you wish to discuss any aspect covered in this Newsletter