Defaqto

What is an ‘unsecured pension?’

This is the facility to take up to 25 per cent of your fund as tax free cash, and leave the remainder of your pension fund invested. In the meantime, you can take income as and when you need it from the fund, subject to certain Inland Revenue limits, but you are not obliged to take any income at all, if you don’t need it.

You can do this until age 75 when you are obliged to either buy an annuity or transfer the fund to an Alternatively Secured Pension or ASP.

The minimum income you can take from an unsecured pension is between nil and roughly 120 per cent of what a single, level annuity would pay someone of your age. Unsecured pensions replaced "income drawdown" when the new rules for pension simplification came into force on 6 April 2006.

The advantages of taking an unsecured pension

Taking an unsecured pension has a number of advantages including:

• income flexibility - each year the amount of income taken can be varied between the minimum and maximum limits. Income can also be taken monthly, quarterly, half yearly or annually.
• control over your investments - if the unsecured pension is set up through a self invested personal pension or Sipp, there is a wide range of investment options available.
•  choice of death benefits - unlike annuities where the only death benefits available are from a joint life, guaranteed, or money back annuity, drawdown offers a choice of death benefits.

The disadvantages

When you buy an annuity, you give up control of your pension fund in return for a secure income. With an unsecured pension, you maintain control of the pension fund but your income will not be secure, so it is a much more risky option than buying an annuity.

There are a number of risks involved when you defer an annuity purchase by investing in an income drawdown plan. Understanding and knowing how to manage these risks is very important.

• Investment risk – the value of your investments can go down as well as up.
• Mortality drag - if you defer purchasing an annuity, you will miss out on the mortality cross subsidy. The extra return required to compensate for the absence of this subsidy is called mortality drag.
•  Decrease in your annuity purchasing power – If annuity rates fall and the value of your pension fund does not increase sufficiently to compensate, an annuity purchased in later years will provide less income compared to purchasing an annuity now.

Income limits

The amount of income that can be paid from an Unsecured Pension fund is determined by reference to tables produced by the Government Actuary's Department (GAD).

The maximum income in any one year is roughly equal to 120 per cent of what a level, single life annuity would pay someone of your age, while there is no minimum income requirement. This means that you can choose to take no income each year if you so wish.

To ensure that the income limits from drawdown are in line with annuities, the limits are calculated by reference to current gilt yields. GAD produces a set of special tables based on a range of interest rates.

Income Flexibility

Income can be varied each year so long as it is kept within the GAD limits. Income withdrawals can be paid monthly, quarterly, half yearly or annually and can be in advance or arrears.

Five-yearly reviews

Short term annuity

Tax simplification introduced in 2006 means that there is now a new option whereby you can choose to secure part (or all) of your unsecured pension through the purchase of a short-term annuity contract from an insurance company.

The term of that annuity contract cannot be more than five years, and the annual amount payable by the contract is bound by the same rules as income withdrawal payments paid direct from the scheme.

The term of that annuity must not extend beyond your 75th birthday.

By buying a short term annuity, you can reassess your pension needs periodically and choose alternative types of annuity, so long as you use up the rest of your fund to purchase an annuity by age 75 (unless you want to continue doing income drawdown via an Alternatively Secured Pension (more on this below).

Drawdown - death benefits

For many people, what happens to the pension fund when you die is the most important feature of drawdown.

By contrast, if you buy an annuity, there is no return of fund to your dependants (unless you have purchased a joint life, guaranteed or money back annuity).

On your death before age 75 there are three options:

• take a lump sum death benefit – this means your surviving spouse, registered civil partner or dependant takes the remaining pension fund as a capital sum, less a 35 per cent tax charge. The lump sum payment will be free of IHT, providing the correct trust has been set up.
• continue taking unsecured pension - a surviving spouse or dependant may continue taking income withdrawals.
• annuity purchase - a single life annuity can be purchased for your spouse or dependant.

Alternatively Secured Pension (ASP)

ASP is a new option that allows you to avoid purchasing an annuity at the age of 75 by continuing with a limited form of unsecured pension.

Income Limits

If you take an Alternatively Secured Pension or ASP, an income will be paid to you from your pension fund in much the same way as for an unsecured pension before age 75.

The maximum permitted income is roughly equivalent to 90 per cent of what a single life, level annuity would pay to someone aged 75. The minimum income is 55 per cent, also based on what a single, level annuity would pay to someone age 75.

However, as you grow older, the maximum income remains based on the equivalent annuity payment for someone aged 75, so your income will not increase with age.

The income limits are reviewed every year and the amount of income you take within these limits can be changed each year, providing you do not exceed the maximum.

What happens to your pension fund on death after age 75

On death, any remaining ASP funds must be used to provide benefits for any surviving dependants. Your spouse or partner will be considered a dependant, as will children under the age of 23, who are in full time education.

Benefits paid to dependants must be in the form of income. This means there is no lump sum (cash) death benefit payable to dependants.

So income can be paid as:

• a lifetime annuity;
• an unsecured pension, if the dependant is under age 75;
• or as ASP, if the dependant is over age 75

If there are no living dependants, the remaining funds can be paid as a lump sum death benefit. The payment will be

• tax free, if paid to a charity of your choice;
• any payments to individuals, or transfers to other pension funds, are treated as "unauthorised" payments. This means such payments will incur a tax charge of 82 per cent (consisting of 70 per cent tax on the pension fund and 40 per cent inheritance tax).

Phased retirement

This is a very tax efficient way to take your pension income. Your pension plan is set up as typically 1,000 segments and each year you convert a number of these segments into tax free cash and an income bought via a mini annuity.

Each vested segment is taken partly as tax-free cash (normally 25 per cent) and the remainder as a mini annuity. The tax-free cash is added to the annuity and the two together provide income for that year. As a large part of the total annual income comprises tax free cash, it is clearly very tax efficient as income tax is only payable on the annuity element.

In subsequent years, further encashments are made to provide more tax-free cash and income, in addition to the annuities already in payment. Therefore, there will be a number of different annuities and each one can be purchased on a different basis (if required) - for instance, with profits, investment, single or joint life, level or escalating.

Deciding between an annuity and Unsecured Pension

Deciding between an annuity and pension drawdown can be a very difficult decision because there are various factors to consider depending on your retirement objectives.

As you do this, you will realise that you probably have more than one objective and there is no one type of annuity or drawdown that will meet all of these objectives.

This is why it may be in your interests to mix and match your pension fund by splitting it up and using part of the fund to buy a mix of annuities and using the remainder to take an unsecured pension or ASP, depending on your age.

The table below sets out the some of the most important objectives with a comment about which product meets these objectives.