Pension Withdrawals - Secured Pensions
Secured Pension
This will either be a lifetime annuity or a 'scheme' pension.
- A lifetime annuity is simply an annuity payable by an insurance company which the member has chosen. Most lifetime annuities are not investment linked, although it is possible to purchase a with-profits or unit linked annuity
- A scheme pension is provided by a pension scheme or, where the pension is payable by an insurance company, it is selected by the scheme administrator
- A defined benefit scheme can only pay a scheme pension
- A money purchase scheme can also pay a scheme pension. Whilst, however, it is possible for a money purchase scheme to elect to pay a scheme pension out of their own funds on a 'pay as you go' basis, very few schemes will actually do this in practice
Both lifetime annuities and scheme pensions:
- Must be paid at least yearly
- Can be secured on a single or joint life basis
- Can include a guarantee period which ensures that the pension is paid for a minimum period, regardless of when you die
- Can include capital protection, which pays a lump sum on death
- May be transferred to another provider, but no further tax-free cash is available following transfer
- Can be level or increase in payment
A potentially important difference between a lifetime annuity and a scheme pension however is the way that they are tested against the lifetime allowance when benefits are taken.
Secured pension and the lifetime allowance
If it is a scheme pension, the deemed value of the benefits being taken is 20 times the initial annual rate of pension plus the value of any tax-free cash.
If it is a lifetime annuity, it is simply the total value of the fund (the 'purchase price') before any tax-free cash is paid.
Depending on the type of pension purchased, therefore, using the 20 times pension formula for a scheme pension from a money purchase scheme can lead to either a higher or lower value than the actual value of the fund.
What this means in practice is that if the cost of securing a scheme pension is more than £20 of fund per £1pa of pension (i.e. equivalent to an annuity rate of less than 5%) then the scheme pension route will use up less of the lifetime allowance. However, if the cost of securing the scheme pension is less than £20 of fund per £1pa of pension (i.e. equivalent to an annuity rate of more than 5%) then the scheme pension route will use up more of the lifetime allowance.
For someone not close to their lifetime allowance, this will not be an issue but in situations where choosing a scheme pension could potentially give rise to a lifetime allowance charge, this could be an important factor to consider.
Conventional Annuities
The amount payable depends primarily on:
- The Purchase Price
- The amount of tax-free cash taken
- The ancillary benefits chosen (such as escalation and survivor pensions)
- The client's age
- The client's state of health
- Current gilt yields
Level v Escalating
A level annuity pays the same amount of income year after year. It pays a higher income compared to the initial starting income available under an escalating annuity, which will take a number of years to catch up and exceed a level annuity.
An escalating annuity, on the other hand, increases each year. The higher the level of escalation chosen, the lower the initial income.
It is possible to select a fixed rate of increase each year normally in the range of 3% to 7.5%. Alternatively, you can choose to link increases to reflect changes in the Retail Prices Index (RPI). However, if you select an RPI linked annuity, your income is not guaranteed to increase each year as the RPI may not rise, and if it fell, so would your income. Annuities can also escalate in line with Limited Price Indexation (LPI). LPI means your income increases each year in line with the RPI but subject to a maximum of 5%.
Joint life annuity
A joint life last survivor annuity pays an income until the second person dies. For annuities bought before 6 April 2015, only a surviving 'dependant' of the deceased (normally their spouse or civil partner) could receive these payments. For joint life annuities bought after 5 April 2015, however, the tax rules have been changed to allow joint life annuities to be paid to any beneficiary.
The annuity can continue at the same level to a survivor although most people elect for the income to continue at a rate of either 1/2 or 2/3 of the amount payable on first death.
Frequency of Income
You must select at outset how often you want to receive income each year. Most people choose monthly, but you can be paid quarterly, half-yearly or annually.
Income paid in advance or in arrears
Payments can be made either in advance or arrears. If you opt for monthly income and purchase your annuity on 1st May and you receive your payment on that day, you are being paid in advance. If your first payment is not made until 1st June, you are being paid in arrears.
With Or Without Proportion
If paid in arrears, the payment can be with or without proportion.
With Proportion means that if the annuitant dies in-between annuity payments, a proportion of the outstanding annuity payment is paid up to the date of death. This option is most valuable when income payments are made on an annual basis.
Without Proportion means that the annuity ceases on the last payment made prior to death.
Taxation of Income
Annuity income paid to the original annuitant will be subject to income tax at their marginal rate(s). If a joint life annuity has been purchased, however, how the annuity income paid to the survivor will be taxed will depend on whether or not the original annuitant died before or after age 75.
- If death occurs before age 75, the annuity income will be tax-free in the hands of the surviving beneficiary, but
- If death occurs on or after age 75, the annuity income received by the surviving beneficiary will be subject to income tax in their own hands based on their own marginal rate(s)
Capital Protection
Also known as ‘value protected’ annuities these enable the annuitant to protect part, or all, of the initial amount used to buy the annuity which will then be paid as a lump sum on death to a nominated beneficiary where the amount of the lump sum will be the protected amount less the gross annuity instalments already paid less (if relevant) a tax charge where for lump sum payments made after 5 April 2015:
- If death occurs before age 75, this tax charge is 0%; but
- If death occurs on or after age 75, this tax charge is levied at the recipient's marginal rate (reduced from a flat rate tax charge of 45% in 2015/16).
If a tax charge does apply, the tax must be deducted by the scheme administrator before the lump sum is paid but if, as an example, the initial annuity purchase price (net of tax-free cash) was £100,000 and the annuitant died after receiving gross annuity payments of £20,000 the gross amount payable (before deducting any tax payable if the annuitant does die after they have attained age 75) would be:
- £100,000 - £20,000 = £80,000 if 100% protection had been selected
- £75,000 - £20,000 = £55,000 if 75% protection had been selected: or
- £50,000 - £20,000 = £30,000 if 50% protection had been selected
Guarantee Periods
Choosing a guarantee period ensures that the annuity is paid for a minimum period, regardless of when you die, and a choice of either 5 or 10 years is normally available.
From 6 April 2015, however, the 10-year limit on guarantee periods has been removed, thus enabling guarantee periods of any length to be offered by providers. The guarantee means that, on your death, your estate or a nominated beneficiary would continue to receive the balance of any annuity payments due between the date of your death and the end of the guarantee period. Alternatively, from 6 April 2015, the outstanding balance on death during a guarantee period could instead be commuted and paid as a lump sum as long as the amount payable is less than £30,000.
Payments under a guarantee period can be paid to any nominated beneficiary; they do not need to be paid to a financial dependant such as a spouse.
Impaired Life/ Enhanced Annuities
Some annuity providers offer annuities which pay you a higher than normal income if you have a medical condition which can reduce your normal life expectancy. These will either be 'enhanced' or 'impaired life' annuities.
An impaired life annuity is for people who have a shortened life expectancy due to a chronic and usually terminal illness, typically where life expectancy is less than 5 years.
An enhanced annuity is available for less severe ailments for people who suffer from one or a combination of health or lifestyle conditions, where life expectancy is reduced to a less significant extent. Examples of conditions that will qualify for an enhanced annuity include angina, high blood pressure, high cholesterol, obesity, smoking and asthma.
Some providers also offer improved terms to people who have had particular occupations or live in certain parts of the country.
Advantages of a conventional annuity
- Annuity rates may be attractive – especially if your existing provider offers valuable guaranteed annuity rates or if you would qualify for an enhanced or impaired life annuity
- You will receive a guaranteed level of income for life
- Your annuity can include capital protection that will pay a lump sum on your death or include a guarantee period in order to ensure that the annuity is paid for a minimum period regardless of when you die
- You can access the tax-free cash sum immediately
- You may exceed your life expectancy and 'profit' from your annuity
Disadvantages of a conventional annuity
- Annuity rates may be low
- If a level annuity is selected, the real value of the annuity will erode over time
- The level of income cannot be varied to accommodate changing personal financial circumstances
- Ancillary benefits, such as a spouse's pension, must be selected at outset and cannot be changed
- It may be the case that you do not exceed your life expectancy and therefore suffer a 'loss' as a result of buying an annuity
Phased Retirement (Annuity Purchase)
Most personal pensions are arranged not as a single plan, but as a cluster of many separate plans, often called 'segments'. These segments can then be used to buy annuities at different times both before and after you reach the age of 75. This process is called 'phased retirement'.
Each time you convert a segment to an annuity, you can first take part of the segment's fund as tax-free cash (normally 25% of the segment). Converting segments regularly, and typically once a year, means you can effectively use the tax-free cash, as well as the annuity, to provide you with your income.
The main drawback is that if you stagger the conversion of segments into annuities you will not be able to take all your tax-free cash from your total pension fund at outset as a single lump sum payment.
Phased retirement, however, can be a very useful financial planning tool, especially if you want to ease back gradually on work and start to replace your earnings with pension income.
Advantages of Phased Retirement
- Can phase in income in line with income needs
- Tax-free cash can form part of the income stream
- Delayed commitment to the type of annuity for the whole fund can be very useful if you are unsure about your own or your spouse's health
- Annuity rates should improve with age
- Uncrystallised funds remain invested and grow virtually tax-free, potentially generating higher income and tax-free cash
- Uncrystallised funds (as-well as any funds that may have been designated to pay a drawdown pension) can be paid out as a tax-free lump sum on death before age 75.
Disadvantages of Phased Retirement
- Maximum tax-free cash not available at outset
- Investment performance could be poor
- Annuity rates could get worse
- The need for regular reviews of both investment performance and income means it is more complex and expensive than converting the whole fund to a conventional annuity at outset
Flexible Annuities
In line with its commitment to deliver a more flexible pensions' regime, from 6 April 2015 the Government will now allow product providers to sell annuities that can increase and decrease in payment. For example, an annuity could increase in payment each year for the first few years then decrease in payment once a pensioner reaches state pension age.
Past performance is not a guide to future performance. Changes in the exchange rate will affect the sterling value of your investment. The value of investments (including property) and the income derived from them may go down as well as up.