Income drawdown

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 (ASP).

The minimum income you can take from an unsecured pension is between nil and roughly 120% of what a single life 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, although the term is still commonly used.

The advantages of taking an unsecured pension

• 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 (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 of an annuity

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 fund but your income will not be secure, so it is a much more risky option.

There are a number of risks involved when you invest in an unsecured pension. Understanding and knowing how to manage these risks is very important and professional financial advice is encouraged.

• 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.

What are 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% of what a level, single life annuity would pay someone of your age; there is no minimum income requirement.

To ensure that the income limits from drawdown are in line with annuities, the limits are calculated by reference to current gilt yields.

Income flexibility

Income can be varied each year, so long as it is kept within the prescribed GAD limits. Income withdrawals can be paid monthly, quarterly, half yearly or annually and can be in advance or arrears. Income withdrawals can also be taken on an ad hoc basis if required and if permitted by the product provider.

Why are there five-yearly reviews?

There is a compulsory review of unsecured pension arrangements every five years to ensure that your pension fund can sustain future income payments. At the review, the minimum and maximum income limits are set for the next five years.

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 directly from the scheme.

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

By buying a short term annuity, you can re-assess 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 ASP).

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:

• 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% tax charge. The lump sum payment will be free of inheritance tax, providing the correct trust has been set up;
• Continued 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.

If you take an 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% of what a single life, level annuity would pay to someone aged 75. The minimum permitted income is 55% of what a single life 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, which means there is no lump sum death benefit payable to dependants.

So income can be paid as:

• A lifetime annuity
• An unsecured pension, if the dependant is under age 75
• An 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% (consisting of 70% tax on the pension fund and 40% inheritance tax).

Should I consider 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%) 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.

If you die before age 75, any unused pension segments are paid out free of tax. In addition, there may be ongoing payment from the annuities already in payment to your dependants, such as from the balance of any guaranteed period and or a spouse's pension.

Annuities versus unsecured pensions

Deciding between an annuity and unsecured pension 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.

Objective	Comment
Sustainable income for the rest of your life	Only annuities can insure against longevity because they are based on the concept of mortality cross subsidy. With drawdown (unsecured pension or ASP) there is a significant risk that income levels may reduce in the future because there is no mortality cross subsidy and you might not achieve the required investment returns. However, drawdown does provide the opportunity to outperform an annuity and there is more flexibility.
Keeping place with inflation	Inflation reduces the future value of your income. Level annuities may be storing up trouble for the future if high inflation returns, but inflation linked annuities will pay you a lower income at the outset. Only an index linked annuity can guarantee to maintain its real value over time. For those who believe that in the long run, equities are a good hedge against inflation, a with-profit or unit linked annuity could be considered instead of an index linked annuity. A drawdown (unsecured pensions or ASP plan) with the appropriate investment strategy should be able to provide an income stream that at least keeps pace with inflation.
Flexibility	There is no flexibility with a standard annuity but the income is guaranteed. Flexible annuities provide a certain amount of flexibility with income levels and control over your investments, but they are fairly complex. Drawdown (unsecured pensions and ASP) provides flexible income options, investment control and choice of death benefits. However, drawdown plans can be costly and you can run the risk of a lower income in the future.
Financial security for family	Most annuities do not provide a lump sum when you die, unless they have been set up with a spouse's pension and/or a minimum guarantee period of five or 10 years. Drawdown (unsecured pensions) provides better death benefits by allowing a lump sum death benefit (less 35% tax) to be paid (if the plan holder dies before age 75) or continued income for spouse and or dependants. Even better death benefits are available with phased retirement.
Not taking undue risk	The main risks to consider in retirement are: the risk of income falling, inflation risk, investment risk and the risk that your circumstances may change. No one policy can manage all these risks, which means that even an annuity is not risk free. Those prepared to take a certain amount of risk, in return for extra flexibility and control, will be attracted to drawdown. For those who are not risk averse, but do not want to take all the risks associated with pension drawdown, with profit annuities may be considered.