Income drawdown

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Income Drawdown is a method withdrawing benefits from a UK Registered Pension Scheme.[1]. It is only possible for those who own, or transfer to, a Personal Pension.

Capped Income Drawdown permits the policy holder to withdraw an annual income between nothing and a maximum based on the initial fund value, their age at the time, and the current rates set by the UK Government Actuary's Department. The maximum is revised every three years until the 75th birthday and thereafter at annual intervals. The individual can choose to buy an annuity at any time. Individuals who can demonstrate that they have guaranteed pension earnings of twenty thousand pounds or more can use Flexible Income Drawdown. This permits unlimited withdrawals. All withdrawals are treated as taxable UK income.

Income drawdown commences whenever the individual withdraws the allowable Pension Commencement Lump Sum (a tax free lump sum of up to 25% of the scheme value) and a life annuity is not purchased with the remainder. The Income Drawdown fund is also known as a crystallised pension fund. It is possible to crystallise a pension in stages, though it must be completed by the individual's 75th birthday.

Background[edit]

The “mandatory annuitisation of pension funds” dates back to the Finance Act 1921. A requirement to annuitise between the ages of 60 and 70 was introduced by the Finance Act 1956. The upper age limit was increased to 75 by the Finance Act 1976.

From 1995, in response to falling annuity rates, Income Drawdown was introduced as an alternative way of drawing an income and, under the original rules, purchasing an annuity no later than the 75th birthday.

The limits for withdrawal, set by the Government Actuarial Department, set limits to the withdrawals based on the age of the individual and the existing Gilt yield. Originally the minimum and maximum withdrawal rate was set at 35% and 120% of the an amount that broadly reflected the annuity that could have been bought based on a single life basis with no annual increase.

To prevent the erosion of capital a review was conducted every third anniversary, with new limits being set based on the individual's age. the Gilt rate and fund size at the time. The requirement for a minimum income withdrawal was later removed

Pension reforms in 2006 extended the option for drawdown beyond age 75, but with greater restrictions. At that time income drawdown was given the alternative name of an unsecured pension (USP) prior to age 75 and an alternatively secured pension (ASP). Neither provided a secured status. Income limits were capped at 100% of the relevant GAD rate for USPs and 70% in respect of ASPs. For ASPs the limits of 55% to 90% applied. These reforms also redefined the review period as every five years for USPs and annually for ASPs

After April 2011, Drawdown has been reintroduced as the common term and those under 75 can withdraw up to 120% of the GAD rate. Once again Review dates occur every three years for those under 75 and annually thereafter. The requirement to buy an annuity at 75 was removed.

Regulatory Environment[edit]

Current Regulatory Environment[edit]

Saving for a pension in the UK is subsidised by tax relief on contributions into an approved scheme. The government therefore imposes regulations on Approved Schemes (largely enforced by HMRC); and Pension Providers and Independent Financial Adviser advising on pension planning are regulated by the UK Financial Services Authority. The effect of the Regulations is that Income withdrawal comes in two forms - capped drawdown and flexible drawdown. So in practical terms drawdown pension can be paid one or more of three ways:

  1. capped drawdown
  2. flexible drawdown, or
  3. through a short-term annuity[1]

Previous Regime[edit]

An Income Drawdown started before 6 April 2011 will have to convert to the new rules, or the pensioner must purchase an annuity. There are transitional rules in place, giving a deadline to do this.[2] Pensioners falling into this category need to read the HMRC guidance on how their unsecured pension needs to be brought in line[3] or consult an Independent Financial Adviser Independent Financial Adviser.

Types of Income Drawdown[edit]

Unless a short term annuity is purchased, Income Drawdown will become one of the following:

Flexible Drawdown[edit]

Flexible Drawdown is only available to a pensioner who is already being paid a secure pension income of at least £12,000 a year (£20,000 pre 27/03/14) and has finished saving into pensions. Anyone qualifying for Flexible Drawdown can withdraw as little or as much income from their pension fund, as they choose, as and when they need it.

Capped Drawdown[edit]

Most Income drawdown is Capped Drawdown. While there is no government imposed minimum income to be taken, the maximum that can be taken is prescribed or “capped”. The limit applies to the total of payments taken as income withdrawal and short-term annuities[4] The new maximum amount of income that may be drawn is 150% (previously 120% pre 27/03/2014) of the single life annuity that a person of the same gender and age could purchase based on Government Actuary’s Department rates. In other words, one's pension provider calculates the maximum income the saver can receive, using standard tables prepared by the Government Actuary’s Department. This can mean that, if a person is in poor health, he or she should take specific advice from an Independent Financial Adviser on his/her personal position, as the pensioner may be better off with an Impaired Life Annuity with guaranteed options.[5] The maximum limit is reviewed every 3 years until age 75 and yearly thereafter. Exceeding the limit will be classed as “an unauthorised payment”.[6] The pensioner will be stung for tax[7] currently[8] between 40%[9] & 55%[10] on the unauthorised payment. In addition to the tax charge imposed on the pensioner, the scheme administrator will have to pay a scheme sanction tax charge of at least 15 per cent of the unauthorised payment[11]

Commencement[edit]

Income Drawdown can be started at the same time as a saver can start to get any authorised pension from a registered pension scheme.[12] Normally this starts at age 55. A person can start drawing a pension earlier if:

  • he or she is retiring due to ill-health, or
  • he or she has a protected pension age which allows him or her to retire earlier than 55.[13]

There is no upper limit for commencement.[14] (Most forms of pension have to be taken before age 75.) Opting for Income drawdown therefore has the advantage of enabling savers to put off drawing any income from their pension savings for as long as it suits them.

Commutation[edit]

When a saver starts Income Drawdown, as with other options for taking a pension, he or she has a one-off chance to take a tax free lump sum of up to 25%.[15] It cannot be done later. This type of lump sum is now called a pension commencement lump sum. Anyone wanting to put off taking a pension commencement lump sum until after age 75, should take independent expert advice from an Independent Financial Adviser about “designation” well before his/her 75th Birthday. Since not all pension providers permit postponement after 75, it may be necessary before the pensioner attains 75 for his/her Independent Financial Adviser to transfer the pension savings to another provider whose internal rules permit this. Whilst the Rules permit transfer, it can be quite a lengthy process in practice and involve investment timing issues (some Providers turn all the pot into cash and transfer a monetary sum to the new provider).

Flexible Planning[edit]

Not all a person’s pension savings have to go into a single Income Drawdown. There are many permutations, but they are beyond the scope of this article: for example part of a saver’s pension savings can be used to buy an annuity Annuity (European financial arrangements) and part put into income drawdown; some or all of a saver’s pension savings can be split, so creating separate sub-funds, which can then put into payment at different times. Some Additions can be made to a pension drawdown fund, as well as further contributions into the scheme providing the drawdown pension, or into another pension scheme.[16] But if a person is considering taking a drawdown pension as flexible drawdown, it is necessary first to consider the tax consequences if s/he wishes to continue making contributions.[17] Even Income Drawdown in payment can be transferred to another pension scheme, subject to observing some conditions.[18]

Taxes[edit]

Income paid under Income Drawdown, like any form of pension in payment, will be taxed as part of the pensioner’s income for Income Tax. In fact, the scheme administrator should deduct Income Tax under PAYE (so the pensioner will only receive the net amount). [unlike the case where a drawdown pension is being paid using a short-term annuity, where there is a possible tax trap. The taxable amount is the amount due to be paid in the tax year under the terms of the contract: so the pensioner may have to pay income tax in a particular tax year even though he/she did not actually get the payment in that tax year.][19]

Differences between Income Drawdown and Annuities[edit]

A key object of Income Drawdown is to structure the fund to allow the pensioner to benefit from future investment performance. Part of the fund can be invested with the aim of matching or beating inflation, to inflation-proof the fund. The excess return, which cannot be paid because of the operation of the cap, can be rolled up within the attractive pension tax wrapper. A pensioner who buys an annuity hands over a capital sum and, in return, the insurance company pays the pensioner an amount stipulated under the annuity contract based on their life expectancy and the assumed returns on an underlying investment. The contract is guaranteed by the insurer for life on the assumption that those living longest will receive the cross-subsidy of those who die earlier. The income may be guaranteed or based on investments that may affect the future level of income. Guaranteed contracts are loosely based on the current fifteen year Gilt rate (gilts being the bonds issued by the UK government. A prospective pensioner in ill-health may be able to buy an impaired life annuity that assumes a shorter life expectancy and would provide a greater level of payment than a standard annuity.

Once a pensioner buys an annuity, no further changes can be made. With income drawdown, a pensioner can stop, start and change income levels at any time, subject to available funds and HMRC limits or they may purchase an annuity at a later date.[20]

Income drawdown carries the risks of investment values going down and GAD rates reducing through changes in life expectancy or interest rates. In addition to this the value of cross-subsidy increases exponentially with age. Within a cohort of individuals starting their annuity at the same age, those living longer than the expected average stand to gain more the greater that age is. Conversely, each of these annuitants is statistically also more likely to provide the cross subsidy to others on early death. The measure of monetary benefit or loss provided by cross-subsidy can therefore only be measured in certain terms with hindsight.

Benefits on Death[edit]

An annuity is a contract that, in return for a capital payment, pays the annuitant an income until death. At the moment the annuitant dies, the annuity becomes valueless as it will not pay anything more, unless the annuitant bought additional benefits when purchasing the annuity. Nowadays annuity providers do provide a number of different add-ons, but each comes with a cost. In contrast, with income drawdown any pension funds remaining on death will be available to the pensioner’s dependents to take as an income or use to buy an annuity. For those with a spouse or civil partner, there are rules about using their fund to buy an income; but subject to that, the fund can be converted to a lump sum for dependents. Such a lump sum is taxed at 55%.[21]

References[edit]

  1. ^ see HMRC´s RPSM09103510 – Technical Pages and http://www.hmrc.gov.uk/manuals/rpsmmanual/RPSM09103520.htm retrieved 19th February 2012
  2. ^ http://www.pensionsadvisoryservice.org.uk/annuities-and-income-drawdown/income-drawdown-plans retrieved on 19th February 2012
  3. ^ RPSM09102350 and RPSM09102400 retrieved on 19th February 2012
  4. ^ http://www.hmrc.gov.uk/manuals/rpsmmanual/RPSM09103520.htm extract HMRC Manual, retrieved on 20th February 2012
  5. ^ http://wexdon.com/impaired-life-annuities retrieved on 20th February 2012
  6. ^ http://www.hmrc.gov.uk/manuals/rpsmmanual/RPSM09103520.htmretrieved on 20th February 2012
  7. ^ Finance Act 2004 Part 4 Chapter 5 s208 Unauthorised Payments Charge http://www.legislation.gov.uk/ukpga/2004/12/section/208 retrieved on 20th February 2012
  8. ^ Ibid s208(6) & s209(7) giving the Treasury power to change the tax rates by Order
  9. ^ ibid s208(5)
  10. ^ ibid s209(6)
  11. ^ Finance Act 2004 Part 4 Chapter 5 s239 & s240 provide, in effect that a 40% charge is usually reduced to 15% http://www.legislation.gov.uk/ukpga/2004/12/section/240 retrieved on 20th February 2012
  12. ^ Pension Rule 1 in s165 Finance Act 2004, see http://www.legislation.gov.uk/ukpga/2004/12/section/165
  13. ^ see RPSM03106000 & http://www.hmrc.gov.uk/manuals/rpsmmanual/RPSM03106040.htm retrieved on 20th February 2012
  14. ^ Pension Rule 6
  15. ^ http://www.hmrc.gov.uk/manuals/rpsmmanual/RPSM09103520.htm retrieved on 20th February 2012
  16. ^ This will be subject to HMRC limits
  17. ^ RPSM09103590retrieved on 20th February 2012
  18. ^ See Reg 12 of The Registered Pension Schemes (Transfer of Sums and Assets) Regulations - SI 2006/499
  19. ^ http://www.hmrc.gov.uk/manuals/rpsmmanual/RPSM09103520.htmretrieved on 20th February 2012
  20. ^ If you have contracted out benefits (called protected rights) in your fund you have to provide an annuity for your spouse/civil partner if married or in a civil partnership
  21. ^ http://www.hmrc.gov.uk/pensioners/passing-tax.htm#4 retrieved on 20th February 2012