your retirement
options
Beaumont Robinson Independent Financial Advisers
This report has been prepared by Beaumont Robinson
July 2011
Introduction
2
Benefit Crystallisation Events
3
Protected Rights
4
Pension Commencement Lump Sum
5
Lifetime Annuities
6
Scheme Pension
10
Drawdown Pension
12
Third Way Pensions
18
Phased Retirement
21
Triviality
24
Quick Guide Summary
25
Beaumont Robinson Independent Financial Advisers
There are several options available to you with regards to drawing your retirement benefi ts. This guide is intended to provide a starting point to help you understand more about these options.
In particular, this guide covers:
• crystallising your benefi ts;
• pension commencement lump sums (tax free cash); • pension income options; and
• phasing your retirement benefi ts.
The information in this guide applies to money purchase
pension plans which can be:
• an individual / group stakeholder pension plan; • an individual / group personal pension plan; • a Retirement Annuity Contract (RAC);
• a Free Standing Additional Voluntary Contribution (FSAVC) plan; • an Additional Voluntary Contribution (AVC) scheme;
• a group money purchase pension plan; or • a Section 32 Buyout plan.
The guide does not deal with occupational defi ned benefi t pension schemes, where your retirement benefi ts are directly linked to your salary.
Please note that this guide is for information only. It must not be construed as ‘advice’ for the purposes of the Financial Service & Markets Act 2000 or otherwise. It is based on our understanding of current legislation, which may be subject to change.
Overview
At the point you become entitled to benefi ts in a registered pension scheme, HMRC deem that a Benefi t Crystallisation Event (BCE) has occurred. For example, this could be when you become entitled to:
• a pension commencement lump sum (tax free cash); • a scheme pension;
• a lifetime annuity; or • a drawdown pension.
Becoming entitled to your benefi ts in this sense doesn’t mean the date you reach your normal retirement age under the scheme. It is the point at which you have decided to take your benefi ts from the scheme, and the scheme administrator has all the completed paper work in connection with this.
It also occurs when you reach age 75 and have not yet taken any benefi ts, as well as when lump sum death benefi ts are paid out to benefi ciaries.
The Lifetime Allowance
At a BCE, your pension benefi ts are tested against the Lifetime Allowance. The Lifetime Allowance represents the maximum value all your registered pension scheme benefi ts can be worth, in total, without incurring a tax charge.
For the 2011/12 tax year this fi gure is £1.8 million. From 2012/13 it is set to reduce to £1.5 million. If the total value of your registered pension schemes exceeds the Lifetime Allowance at a BCE, an extra tax charge will be levied of:
• 55% - if the excess is taken as a lump sum; or
• 25% - if the excess is taken as taxable pension income.
Death Bene
fi
ts
Any benefi ts that have not yet been taken are deemed to be ‘uncrystallised’ whilst you are under the age of 75. Should you die with an uncrystallised money purchase pension, then the fund can normally be paid to your nominated benefi ciaries free of tax.
Those benefi ts that have been taken, or where you are age 75 or over, are deemed to be ‘crystallised’. The tax on any lump sum death benefi ts in this case is 55% from April 2011.
Death benefi ts are covered in more detail for each of the pension options. Death benefi ts may be restricted if you have an ‘Protected Rights’, which are covered next…
Beaumont Robinson Independent Financial Advisers
What are they?
If you are employed, part of the State pension you can receive is related to your earnings. The two main earnings related State pensions are the State Earnings Related Pension Scheme (SERPS) and State Second Pension (S2P) which superseded it from 6 April 2002.
It is possible to ‘contract-out’ of these schemes via occupational pension schemes or personal pensions (including stakeholder pensions). An individual who contracts out via a money purchase pension
continues to pay the normal rate of national insurance contributions, but the pension scheme receives an age related rebate from the Department for Work and Pensions. These rebates are then invested along with the other contributions.
The part of the fund that is provided by the rebate is called ‘Protected Rights’. Protected Rights are ring-fenced from the rest of the pension fund and are subject to certain restrictions.
6 April 2012 Changes
From 6 April 2012, the option to contract out via a money purchase arrangement will be removed. Protected Rights will cease to exist; therefore, there will no longer be a requirement to hold Protected Rights benefi ts separately.
Until then, if you do have any Protected Rights, it is important to be aware of how these restrictions may affect you.
Uncrystallised Death Bene
fi
ts
If you are married or in a civil partnership when you die, the whole of the Protected Rights fund must be used to provide an income for your spouse/ civil partner.
If you are not married or in a civil partnership when you die, the Protected Rights fund can be paid either to your estate, or to a benefi ciary as directed by you before death.
As the trustees have no discretion as to who to pay it to it may be liable for IHT. If the value of all your benefi ts is more than the relevant lifetime allowance, the excess will be taxed at 55%.
Crystallised Death Bene
fi
ts
If you are a member of a registered pension scheme you will normally be able to take up to 25% of your benefi ts tax free as a Pension Commencement Lump Sum (PCLS) at, or around, the time your pension starts to be paid (ie when you ‘crystallise’ your pension benefi ts). Up to 25% of Protected Rights can be taken as a PCLS.
The PCLS could be more than 25% if your benefi ts built up in an occupational pension scheme prior to 6 April 2006. This is due to the different method of calculating tax free cash that applied prior to this date. The earliest age at which you can take the PCLS is 55; although you may be more restricted than this depending on the rules of your pension scheme. From 6 April 2011 there is no longer a maximum age of 75, but again you will be subject to the rules of the scheme.
Once you have drawn your PCLS, subject to certain limits, you cannot use the proceeds to pay a further contribution to a registered pension scheme. This is known as ‘recycling’ and there are tax consequences involved.
The balance of your pension fund must then be used to provide a pension income.
The following sections discuss the different pension
income options:
• Lifetime Annuity • Scheme Pension • Drawdown Pension • Third Way Pension
It is also possible to take your benefi ts in stages, known as Phased Retirement, or even to commute them for a lump sum under the Triviality rules if they are very small. These are discussed towards the end of this guide.
Overview
A lifetime annuity is a contract that provides you with a taxable income for life in return for
giving up your rights to your pension fund. Annuities are usually provided by insurance
companies. You have the right to choose a lifetime annuity from any provider on the market.
This is called the ‘open market option’.
There are different types of lifetime annuity available. The three main ones are: a conventional annuity;
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an investment linked-annuity; and
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an enhanced/impaired life.
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Although they all have similar features, there are some differences which we will discuss.
Income
With all annuities, the level of taxable income you receive is dependent upon your age, sex, annuity rates at the time, the size of your fund and the options selected. Some providers take into account your post-code, as average life expectancy varies depending on where you live. Annuity rates tend to mirror interest rates and fl uctuate in accordance with economic conditions.
Annuity payments are taxed at source under the PAYE system. Provided a P45 is presented the annuity will be paid net of your marginal rate of tax and there will be no further tax liability.
Payments can be made monthly, quarterly, half yearly or yearly and can be in advance or arrears. Pay-ments can remain level or can increase at a set rate or in line with an index such as the Retail Prices Index (RPI). Please note that choosing an escalating income will give you a lower starting income that you would get if the payment were to remain level for life.
Death Bene
fi
ts
The option of what death benefi ts to include must be made at outset. The more benefi ts included, the greater the cost. This will mean a lower level of income in return for your pension fund.
The options available are as follows:
Dependant’s Pension
A pension can be paid to a dependant of up to 100% of the pension you had received. The defi nition of a dependant is broadly:
Your spouse or civil partner, either at the time of your death or, dependent on the provider, when you
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fi rst became entitled to take your retirement benefi ts.
Your children (adopted children are included but not stepchildren), up until they reach the age of 23.
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Anyone else that the provider deems to be in some way dependent on you at the time of your death.
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Pensions for your spouse or civil partner will normally be paid for life, but they can be set up to stop if he/ she were to remarry.
Guarantee Period
A guaranteed period of up to 10 years can be added, which will ensure that if you die within the fi rst 10 years, the remaining payments you would have received continue to be paid. These payments do not have to be made to a ‘dependant’. They are taxed as pension income on the recipient through PAYE. It is not possible to commute these payments for a lump sum.
Annuity Protection
Commonly known as ‘value protection’, this option can be included to ensure that on death the original fund value, less the gross income payments already made, can be paid out as a lump sum less a fl at rate tax charge of 55%. This is offered at the behest of the provider.
Please note that from 6 April 2011 the tax charge applying to value protection increased from 35% to 55%.
Protected Rights
If you have a spouse/ civil partner at the point in which you buy an annuity, then you must provide a 50% spouse’s annuity. It can be guaranteed for up to fi ve years. If you do not have a spouse/ civil partner then there is no requirement to do this.
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Types of Annuity
As mentioned, there are different types of annuity.
Conventional Annuity
Most annuities are paid at a fi xed rate which either remain level throughout your life or rise at a pre-deter-mined rate, such 3% a year. Some can be index-linked, such as to RPI. In either case, the income with this type of annuity cannot fall and is not dependent on the performance of the underlying investments.
I
nvestment-Linked Annuity
The pension income from investment-linked annuities can go up or down and is dependent on the per-formance of the underlying investment fund. The most common underlying investment is in ‘with-profi ts’. Under a with-profi t annuity, an assumed future bonus rate is selected at outset. The higher the assumed rate, the greater the level of initial income; however, if the actual bonus rate of the with-profi t fund does not equal the assumed rate then the amount of pension payable will decrease. Conversely, if the actual bonus exceeds the assumed rate, then the pension payable will increase. Most with-profi t annuities offer a minimum guaranteed level of pension income.
If other unit-linked funds are used the initial pension and future income levels are dependent on the per-formance of these underlying unit-linked funds. Often, you are allowed to assume a future rate of growth. The higher this assumed rate the greater the initial income; however if the actual growth does not match this rate then the amount of pension payable will decrease.
In both cases, the starting level of income under this type of arrangement is likely to be lower than that available from a conventional annuity, and whilst the underlying investment could be expected to grow in the long term and provide a higher future income, there could be falls in the shorter term.
Enhanced/Impaired Life Annuities
Enhanced annuities offer better rates for individuals with lifestyle factors or medical conditions that are likely to shorten their life expectancy. This includes smokers, those that suffer from diabetes and the clini-cally obese. Rates are normally assessed through a points system rather than full underwriting.
Those with more serious health problems may apply for impaired life annuities, which offer higher rates than enhanced annuities as the life expectancy is shorter again. They are a smaller sector of the market and individuals are more likely to be fully underwritten. This could involve a medical examinations and detailed investigation of medical history. It may, however, be worth considering whether an annuity is ap-propriate if life expectancy is very short.
Annuity providers know that not all annuitants will live as long as expected. The providers use this ‘mor-tality gain’ to subsidise current annuity rates. Therefore those clients who die earlier than expected subsi-dise the remaining annuitants. Enhanced and impaired life annuities therefore have a knock on effect on the rates of standard annuities, as this cross-subsidy effect is reduced.
Advantages & Disadvantages
The advantages and disadvantages of lifetime annuities are as follows:
Advantages
An annuity provides you with the guarantee of an income for life and the longer you live, the more
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you gain.
You can elect for your spouse/ civil partner /dependant to receive a guaranteed income in the
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event of your death.
There is no investment risk with conventional annuities.
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The income can be increasing in payment or index-linked. You can elect for benefi ciaries to receive a
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lump sum less 55% tax upon your death.
There are no additional charges applied to the contract once in force. All charges are taken at outset
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and are refl ected in the annuity rate offered.
The contract is simple to understand, there is no need to review the contract and there is minimal
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paperwork needed to start the payment of benefi ts.
Disadvantages
Annuity rates have fallen dramatically since the early 1990s resulting in a considerably lower income
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being purchased with your retirement fund.
The selected income level is fi xed and cannot be varied in response to changing personal fi nancial
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circumstances (excluding potential future increases).
If you buy an annuity linked to the Retail Prices Index, your starting value may be very low and may
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never achieve the value from a level annuity.
The value of the annuity could be eroded by the effects of infl ation.
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There is no opportunity of participating in future investment returns, unless an investment-linked
an-•
nuity is chosen.
Any options to provide benefi ts on death must be selected at outset and will result in a lower initial
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pension payment. These selected benefi ts cannot be altered in the future.
Suitability
Conventional lifetime annuities are most likely to suit individuals who want an absolute guarantee on their pension payments and/or for their spouse/partner. They therefore suit individuals with low attitudes to risk and a requirement for security. They also suit individuals who have relatively small pension funds and those that will be heavily reliant on their pension income.
Investment-linked annuities are suitable in the main for someone with a low to medium attitude to risk who want some guarantee on their pension payments but also want to benefi t from future investment returns.
scheme pension
Overview
With a scheme pension there is a commitment to provide an income for life out of the scheme
resources. Until recently, scheme pension was only available to retiring members of final salary
pension schemes, not individuals with personal pension plans. That changed with the advent
of ‘A Day’ on 6 April 2006, but there are still only few pension providers offering the facility.
A scheme pension differs from an annuity because the income is not determined by reference
to life office annuity rates. Instead, an appointed actuary sets the level of income based on
factors such as age, health, size of fund and anticipated investment returns. The principle is
that if the actuary’s calculations are right, your fund will reach zero on the day you die.
The income will need to be regularly reviewed to ensure that the investment performance
is able to support the income paid, or whether this needs to be reduced. A change in your
health could also generate a review to increase income payments. Income is normally
reviewed every three years.
A scheme pension can be paid either directly from the original pension scheme or, on its
behalf, by an insurance company.
Income
Pension payments are taxed as earned income under the PAYE system as described under ‘Lifetime Annuities’. A scheme pension must be paid at least annually. It can be reduced on the basis of actuarial advice. The scheme may also make provision for income to be increased annually by an agreed method.
Death Bene
fi
ts
The decision about death benefi ts needs to be made at the outset. Provision can be made for the pension to be guaranteed to continue to be paid to your nominated benefi ciaries after your death. The guarantee period can be for up to 10 years. The amount of income that is paid cannot, however, be guaranteed. Alternatively, a scheme pension can be arranged to pay out as a lump sum. It is possible for a scheme to provide both alternatives however a pension that is guaranteed to continue in payment cannot normally be converted into lump sum.
Until 5 April 2012, if you have a spouse or civil partner when your scheme pension commences, you must make provision for 50% of the pension from any Protected Rights funds to be paid to any surviving spouse or civil partner.
Advantages & Disadvantages
Advantages
You will receive an income for life which is based on your circumstances and mortality.
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The income is reviewable as your circumstances change.
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It offers the potential for taking a higher income than capped drawdown in certain situations because it
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is not restricted by HMRC limits.
If carefully managed it should result in maximum income and a minimal fund left on death.
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Disadvantages
An investment portfolio needs to be constructed which will involve some investment risk. This means
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the fund value could fall which could affect your future income levels.
Sustainability of income is reviewed by the actuary every three years and you may be asked to reduce it.
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Any options to provide benefi ts on death must be selected at outset and will result in a lower initial
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pension payment.
These selected benefi ts cannot be altered in the future.
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Suitability
The potential disadvantages and the inherent risks involved make scheme pension suitable only to sophisticated investors, who have specifi c fi nancial planning objectives and are capable of fully understanding the risks involved.
Because of the potentially high level of withdrawal that is allowed, there is signifi cant risk of fund depletion if these are taken. This type of arrangement could be used where there is a specifi c determination to ‘strip out’ the fund, perhaps in conjunction with an Inheritance Tax planning exercise. This may, therefore, be useful for individuals with a shortened life expectancy.
drawdown pension
From 6 April 2011, unsecured pension and alternatively secured pension were replaced by
‘drawdown pension’. There are two types of drawdown pension available:
capped drawdown; and
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fl exible drawdown.
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The main features and differences between these are discussed in this section.
Capped Drawdown
Overview
With capped drawdown, your fund remains invested in a tax-efficient environment. An
annual income can then be taken from the invested pension fund, if required. This income
may vary up to a maximum limit which is set by HMRC using rates published by the
Government Actuary’s Department (GAD).
This limit is based on your fund size, age, gender and the current 15 year gilt yield.
This maximum limit is broadly equal to 100% of a single life annuity that you could have
purchased at that point.
This limit must be re-calculated every 3 years up until age 75. It is possible to request an
additional review on the anniversary of the plan, but the scheme administrator does not have
to agree to this.
Once the limit has been re-calculated, this sets a new three year reference period. There are
other occasions where the limit must be re-calculated.
From age 75 onwards the maximum limit is reviewed every year. There is no requirement to
stop capped drawdown at any age.
Income
As stated, a pension income does not have to be taken, but if this is required it cannot exceed 100% of the maximum GAD rate. Income drawn from the fund is taxed as pension income under the PAYE system, the same as annuities. Income can normally be paid monthly, quarterly, half-yearly or annually and can be varied each year.
Short-Term Annuity
It is also possible to purchase a short-term annuity with funds in drawdown. The main rules with this are that: The annuity must be payable at least yearly, by an insurance company.
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You must have been given the open market option to choose from any provider in the market, as for
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lifetime annuities.
The annuity cannot be payable for a term of more than fi ve years.
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The annuity cannot have annuity/value protection, but can be guaranteed for up to fi ve years.
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The income payable is counted when considering the overall GAD maximum rate applying.
Death Benefits
The same defi nitions of ‘dependant’ apply to drawdown. If you die whilst in a drawdown pension, the residual fund is available to provide:
a dependant’s annuity, which cannot have annuity protection or a guarantee (in other words a
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dependant’s annuity cannot include any death benefi ts)
a dependant’s drawdown pension (capped or fl exible depending on the dependant’s circumstances);
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a cash lump sum less a tax charge of 55% to any dependants or nominated benefi ciaries; or
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If there are no dependants, or nominated benefi ciaries, the fund can be given to a charity, tax-free.
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Please note that once the decision has been made by a dependant to carry on with drawdown pension, it is not possible to change this to a lump sum.
The tax charge on the lump sum death benefi t increased from 35% to 55% on 6 April 2011.
Please note that, up until 5 April 2012, any Protected Rights fund must be used to provide a spouse or civil partner with an income. If you do not have a spouse or civil partner, lump sum death benefi ts will be paid to your nominated benefi ciaries less tax at 55%. If there are no nominated benefi ciaries it will be paid to your estate. They cannot, currently, be paid to a charity, tax-free.
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Investment Risk
As your fund remains invested, you are subject to investment risks. The GAD rates are based on 15 year gilt yields; therefore the performance of your assets relative to this will affect your maximum limit at review. Excessive withdrawals and poor investment returns will also affect the fund and therefore impact on future income. There is a danger of depleting the fund too quickly, especially if the maximum level of income is drawn from the fund. Should you wish to buy an annuity in the future, you may not be able to secure the same level of income you could have done at the start.
Mortality Drag
As discussed under the ‘Lifetime Annuity’ section, annuity providers know that not all annuitants will live as long as expected. The providers use this ‘mortality gain’ to subsidise current annuity rates. Therefore those clients who die earlier than expected subsidise the remaining annuitants.
Under drawdown pension, you do not benefi t from this cross subsidy and effectively take on the mortality risk yourself.
The longer you delay annuity purchase, the less you will benefi t from the cross subsidy when you
eventually buy an annuity. The impact of mortality can be expressed as an annual percentage rate. This is the rate by which the net investment performance of the remaining personal pension fund would have to exceed the interest rate implicit in an annuity in order to break even. This effect has become known as the ‘mortality drag’.
Critical Yield
Critical Yields provide an indication of the growth rates needed when selecting drawdown. They are illustrated by product providers using a common prescribed basis. There are two types (A and B).
Type A Critical Yield
This is the annual investment return needed to provide, and maintain, an income equal to that which would have been provided if an annuity had been bought in the fi rst place. This is therefore intended to give a direct comparison with buying an annuity.
Type B Critical Yield
This is the annual investment return necessary to provide and maintain a selected level of income. These yields give an indication of whether drawdown pension is suitable from an investment perspective only.
Advantages & Disadvantages
The advantages & disadvantages of drawdown pension are as follows:
Advantages
Drawdown allows you to take a tax-free cash sum without having to take the income which an
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annuity would provide.
It allows you to keep your pension fund fully invested in a tax-effi cient environment, whilst maintaining
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maximum investment control.
You are able to vary the income to suit your personal circumstances, up to a maximum limit.
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You are able to mitigate your liability to personal income tax in certain years.
You can purchase an annuity at any time if your circumstances change.
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The death benefi ts are fl exible.
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Your benefi ciaries can benefi t from your pension fund if you die.
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High investment returns could improve the value of your annuity when fi nally purchased.
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Disadvantages
The investment returns may be less than those shown in the illustrations.
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High income withdrawals may not be sustainable.
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Taking withdrawals may erode the capital value of the fund, especially if investment returns are
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poor and a high level of income is being taken. This could result in a lower income if an annuity is eventually purchased and could also affect the long term fi nancial security of your spouse/partner. Annuity rates may be at a worse level when annuity purchase takes place. Although annuity rates
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generally increase with age, they have fallen dramatically during the past 15 years. This trend may continue.
A careful investment portfolio needs to be constructed which will involve some investment risk. This
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means the fund value could fall which could affect your future income levels.
Withdrawing too much income in early years may have an adverse effect on preserving your pension
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purchasing power or preserving the capital value of your fund.
Increased fl exibility brings increased costs and the need to review arrangements on an on-going
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basis.
There is no guarantee that your future income will be as high as that offered by an annuity purchased
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today.
You may feel the prospect of the future higher income does not compensate for the known income
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available from an annuity now and for the rest of your life.
You may be prevented from withdrawing your chosen level of income due to the action of the GAD
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limits.
There is mortality drag, which increases with age.
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Unlike an annuity, drawdown pension requires continual ongoing advice in view of the continuing investment risk and the greater fl exibility available.
This may include:
annual review meetings and fund valuations;
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advice on levels and method of income payments in line with requirements;
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calculation of minimum and maximum GAD levels of income;
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three yearly GAD reviews;
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tax planning in line with income needs.
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Suitability
Capped drawdown pension would be generally be suited to the relatively sophisticated investor, who is capable of fully understanding the risks involved and has other income in retirement. In this case the individual would not be heavily dependent on the pension plan and could afford to see fl uctuations in its level. It may also be suitable for individuals in poor health or those that are unwilling to buy an annuity. The contract can be a useful tax planning tool and a means of accessing pension fund tax free cash without having to take the full taxable income.
Flexible Drawdown
Overview
This option is available if you can prove you have a guaranteed annual income for life which
is £20,000 or above, known as the ‘minimum income requirement’. Flexible drawdown
allows you to take whatever level of income you wish from your pension fund, without any
upper or lower limit. The cap is therefore removed.
Please note that currently you cannot have fl exible drawdown with respect to any Protected Rights. This is likely to change from 2012 when Protected Rights become ordinary benefi ts.
Minimum Income Requirement
The minimum income requirement is set at £20,000 per annum from 6 April 2011. Payments that can be regarded as relevant income to meet these requirements are broadly:
State pension;
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Scheme pensions from registered pension scheme where there are at least 20 pensioners;
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Scheme pensions from overseas pension scheme;
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Final salary (defi ned benefi t) pension; and
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Lifetime annuities.
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You must give a declaration to your scheme administration including details of your income sources in order to qualify for fl exible drawdown.
Additional Contributions
Once you have started fl exible drawdown you lose the annual allowance. This means that you can no longer make any contributions into a registered pension scheme, and you must stop accruing benefi ts, otherwise you will face the annual allowance tax charge.
In addition, you cannot make any contributions to a money purchase arrangement in the tax year you go into fl exible drawdown.
Income
There is no maximum or minimum limit on the amount that can be withdrawn from the pension. Any amount taken is taxed through the PAYE system as pension income. It is also possible again to purchase short-term annuities when in fl exible drawdown.
Death Benefits
The death benefi ts are the same as for capped drawdown. If the dependant meets the minimum income requirement, then dependant’s fl exible drawdown can be taken.
Investment Risk
Investment risks are still relevant as your fund remains invested.
Mortality Drag
This is also still relevant as for capped drawdown.
Advantages & Disadvantages
The advantages & disadvantages of flexible drawdown are broadly:
You do not receive a set income, but are able to vary it to suit your personal circumstances without
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any limits.
Unlike with capped drawdown, three yearly/annual reviews are not required.
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You can choose to access all your pension benefi ts at once.
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You are able to mitigate your liability to personal income tax in certain years.
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You have the potential to benefi t from good investment performance in a tax-effi cient environment
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and to exercise control over your own investment portfolio.
Disadvantages
Many of the disadvantages and risks associated with capped drawdown will apply, especially if you become dependent on an income from the fund to preserve your standard of living in the future. In addition to these:
You will not be able to make any further pension contributions without tax penalties.
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You will need to consider your income tax situation when taking large withdrawals.
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Not all providers will offer this option, and you may have to transfer to access it.
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Should your circumstances change you may have signifi cantly depleted your pension savings.
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The higher the level of income withdrawal chosen the less that may be available to provide for
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dependants, particularly when the original fund is small and/or investment returns are poor.
Critical Yield
Critical yields should be reviewed as with capped drawdown and taken into consideration when deciding of fl exible drawdown is suitable.
Suitability
Flexible drawdown pension would be generally suited to the relatively sophisticated investor, who is capable of fully understanding the risks involved and meets in the minimum income requirement. In particular, it is suited to someone who is not reliant on the pension to maintain their preferred standard of living, and has signifi cant other assets.
third way pensions
Overview
Against a background of increased volatility in stock markets, perceived poor rates being
offered for lifetime annuities, concerns regarding future inflation and the fact that people are
now living longer there have been new products brought into the retirement market.
These new plans are commonly known as ‘third way’ products and they are already
very popular in the US and Japan. Essentially they fit in between a lifetime annuity and
a drawdown plan, although they are written under the drawdown rules. They offer the
chance to still participate in stock market growth but with guarantees attached to either
income, capital or both.
Whilst each specific product does differ in its features, the ‘third way’ pension is usually
structured in one of two ways:
Annuity
This option is commonly structured as a fi xed term, value protected annuity plan, typically running for fi ve years at a time. There is usually the option to include guarantees to protect maturity values or the level of income, for a set cost.
Unlike a traditional lifetime annuity, these products tend to offer the ability to alter income levels between certain limits and, importantly, also allow the facility to provide a lump sum on death.
Although the plan can run for fi ve years, capped drawdown limits are recalculated ever three years. Therefore, if the maximum drawdown pension goes below the amount payable by your annuity contract then the excess amount will be an unauthorised payment. If fl exible drawdown applies then this is not an issue.
Drawdown Pension
The second type is structured as a drawdown plan, but with the option to apply a guarantee to the initial investment so that your fund value will never fall below what you originally paid into the plan. Some plans also allow all, or a portion, of any growth in the plan’s value to be locked in and a new minimum guaranteed level is then set. Finally, the option to select a guaranteed level of income is also commonly available.
Income
A pension income does not have to be taken but if this is required, any maximum level will depend on whether you are in capped or fl exible drawdown. An income is taxed under PAYE as pension income.
Death Bene
fi
ts
If you die whilst in a ‘third way’ product the death benefi ts can differ depending on how the particular plan you are using has been set up. You therefore need to check the specifi c product terms and Key Features Document. In general however, they tend to fall into two scenarios:
Annuity option -a return of the original purchase price less withdrawals and less a tax charge of 55%.
•
Drawdown option – a return of the fund value at that point less a 55% tax charge. Alternatively, the
•
spouse / dependent may also have the following options available to them: he or she can buy a lifetime annuity with the fund, or
•
he or she can choose to continue taking drawdown income.
•
Advantages & Disadvantages
Advantages
Unless a guaranteed income is selected, you do not have to receive a set income but are able to vary
•
it to suit your personal circumstances, up to a maximum limit, to supplement other sources of income. You are able to mitigate your liability to personal income tax in certain years.
•
You have the potential to benefi t from good investment performance in a tax-effi cient environment and
•
to exercise control over your own investment portfolio.
You are able to add a safeguard in the form of a guarantee to limit any drop in your fund value and
•
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Disadvantages
Lifetime annuity rates may be at a worse level when annuity purchase takes place. Although annuity
•
rates generally increase with age, they have fallen dramatically during the past 15 years. This trend may continue.
The products are often considered to be complicated and because of their lack of similarity they can
•
be diffi cult to compare.
A careful investment portfolio needs to be constructed which will involve some investment risk.
•
If capital guarantees are not included then this means the fund value could fall which could affect your future income levels.
There is no guarantee that your future income will be as high as that offered by an annuity purchased
•
today.
You may be prevented from withdrawing your chosen level of income due to the action of the GAD limits.
•
You may still suffer ‘mortality drag’.
•
If you opt for an annuity version of the ‘third way’ plan the charges are typically built in to the annuity
•
rates offered. If you decide to choose a drawdown version of a ‘third way’ plan, the charges are added on top. Both of these are generally more expensive than a traditional annuity or drawdown plan.
Critical Yield
For drawdown versions of the plan you may be provided with ‘critical yields’ fi gures as discussed under ‘Drawdown’.
Suitability
Both versions of the ‘third way’ plan would generally suit a relatively sophisticated investor, who is capable of fully understanding the mechanics of the plan and the risks involved.
The contract can be used as a useful tax planning tool and a means of accessing pension fund tax free cash without having to take the full taxable income and it importantly allows the individual to defer annuity purchase until their future plans are clearer.
The availability of guarantees allows this type of contract to be suited to more cautious individuals who would not normally suit a drawdown plan; however, the guarantees do come at a cost.
Overview
Most personal pensions can be arranged not as a single plan, but as a cluster of many
separate plans, sometimes called ‘segments’. The segments can then be converted into
pension income (crystallised) at different times. This process is called phased retirement.
Each time you convert a segment into pension income, you can take part of the segment’s
fund as a PCLS (normally 25% of the segment). You can then purchase an annuity with the
residual amount, or designate it as drawdown income if allowed under the plan.
You would have to ensure that enough segments were crystallised to be able to purchase
an annuity each time or, if designating as drawdown income, that there are sufficient funds
to provide the required level of income.
The balance of your pension fund (i.e. the contracts not cashed in or ‘crystallised’ to
provide you with a given level of income) continue to be invested, thus providing you with
the possibility of higher future income. This will depend mainly on how much income you
take out of the pension fund, especially in the early years, and future investment returns.
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Converting segments regularly means that you can effectively use the tax free cash, as well
as an annuity/drawdown pension to provide your income; making it more tax efficient.
Phased retirement can be a very useful financial planning tool. For example, if you want to
ease back gradually on work and start to replace your earnings with pension income. It also
provides more flexible help for your survivors if you die. Segments that have not yet been
converted into annuities/drawdown pension can provide a pension for surviving dependants
or a lump sum, depending on the terms of the pension plan.
If annuitising, it is possible vary the type of annuity on each occasion, and it need not be on
the same basis as the first or subsequent annuities. The main drawback is that if you stagger
the crystallisation of your benefits you will not be able to take all of your PCLS from your total
pension fund at once as a single lump sum.
Income
Pension income is taxed under PAYE as per lifetime annuities and drawdown pension, depending on the income choice you make. If you are using your PCLS as income, then this will more tax effi cient.
Death Bene
fi
ts
The uncrystallised part of your pension can be paid out as a tax free lump sum as long as you are under age 75. From age 75, it will be subject to 55% tax.
The death benefi ts applying to the crystallised part of your pension will be determined by the product you are using (ie annuity or drawdown pension).
Advantages & Disadvantages
Advantages
You can use tax free cash as ‘income’ and thus, for a given level of income, reduce your overall liability
•
to Income Tax.
You retain investment control of the segments of your pension fund not yet crystallised, thus providing
•
you with the possibility of higher future income. This depends largely on how much income you take out of the pension fund (especially in the early years) and the future investment returns achieved on the residual pension fund.
The remaining pension fund not yet crystallised can be returned to your benefi ciaries free of tax on your
•
death before age 75.
You will be able to change the shape of your retirement income to refl ect your personal circumstances
•
in the future; although if combining with annuity purchase, once you have purchased an annuity, this income payment will continue unchanged for the rest of your life. Each year an annuity is purchased you can chose whether to include death benefi ts and other options.
As you get older there is the prospect of annuity rates rising and providing you with higher income then
•
you could get if you purchased one now.
If your market expectations are that medium to long-term interest rates and gilt yields may rise, annuity
•
rates might also rise. If this happens, you will be able to achieve a higher amount of income, through the purchase of an annuity, for the same amount of pension fund ‘cashed in’ then if you were to crystallise your entire plan at the start.
Disadvantages
You cannot access the full PCLS in one payment.
•
There is no guarantee that your income will be as high as if you were to crystallise your benefi ts in full
•
and purchase an annuity at the outset, as annuity rates can go down as well as up, and the value of the continued investment of your pension fund may go down as well as up.
The value of your remaining pension fund, when aggregated with any annuities you may have
•
purchased, may not achieve an equivalent level of income to that which could have been purchased with the whole fund at outset via a lifetime annuity. This is because withdrawals of tax free cash and income will erode the value of your pension fund if investment returns are not suffi cient to make up the balance (including charges for the ongoing administration of the plan).
You may feel that the prospect of future higher income does not compensate you for not being able
•
to enjoy a guaranteed and secure level of income today and for the rest of your life.
Annuity providers make a profi t from the fact that some individuals die sooner than is expected. They
•
utilise some of this ‘mortality profi t’ to enhance current annuity rates.
By delaying the purchase of your annuity, the benefi t of this potential profi t may be lost.
Suitability
Phased retirement is generally suitable only if you have a fairly large pension fund, or have other assets or income to live on. This is because the bulk of your pension savings remain invested, usually in the stock market, which may be more risky than buying an annuity straight away. It is most likely to suit individuals who want to gradually retire such as the self-employed, or those individuals who are likely to be higher rate taxpayers.
triviality
Overview
Where an individual is aged 60 or over, and his/her total pension funds from all occupational
and personal pension plans is less than £18,000, then the entire fund can be paid out as
a lump sum. Commutation of all pension plans must take place within the same 12 month
period. If there is already a plan in payment, the notional value of this must be calculated.
PCLS
A PCLS can still be drawn if has not yet been taken and this will usually be a maximum of 25% of the fund value. If the lump sum is being paid from pension savings that you have already put into payment then the whole sum will be taxable.
Taxation
The remaining fund after the PCLS has been paid will be taxed as earned income under the PAYE system.
Occupational Scheme Members
Where an individual has benefi ts in an employer’s pension scheme that is winding up, they could be entitled to commute their benefi ts under triviality rules before age 60 as long as:
the employer is not contributing to any other scheme for the individual;
•
the employer will not make any contributions for this member for at least a year; and
•
the benefi ts from that scheme in isolation are less than £18,000.
•
Trivially also applies to occupational scheme members who reach retirement age and their fund is less than £2,000. This is provided the scheme rules allow for this. This fi gure is not dependent on other benefi ts from other schemes.
Control of
Pension Fund
Security
of Income Flexibility of Income Flexibility of benefits
LIFETIME ANNUITY
SCHEME PENSION
DRAWDOWN PENSION
PHASED RETIREMENT
No control of fund. Pension fund give
up to provide income
No control of fund. Pension fund give
up to provide income
Retain control of pension fund to provide income
if required.
Pension fund used to
provide income in stages. Control of pension fund
depends on income
option chosen.
Provides a regular and
secure income for life that
cannot reduce.
Provides a regular and secure income for life based on individual life
expectancy – Income can
reduce
Income can be selected if required, but is not secure and not guaranteed
Income is secure if
annuity purchased with segments cashed in, not
secure if drawdown used.
Your income is paid at least annually and can increase or remain level in payment. Increases must
be chosen at outset.
Your income is paid at least annually and can increase, decrease, or remain level in payment. Income reviewed
every 3 years.
Income can vary between nil and 100%, if capped, of an equivalent single life annuity. Max reviewed every 3 years if capped.
Income can be a
combination of tax free
cash and
annuity/drawdown so
flexibility depends which
selected.
All decisions must be
made at outset such as spouse’s benefits and
guarantees.
Decisions must be made at outset such spouse’s benefits and guarantees.
Income and death benefits
are flexible with the
remaining fund available to pay benefits to your family or dependants. There are
no guarantees.
Flexibility depends on what options are taken for pension income.
For benefits not yet taken
maximum flexibility is
available.
Quick Guide Summary
The table below pr
ovides a quick summary of the dif
fer
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Client’s Signature
I confi rm that I have been fully made aware of the associated advantages and potential disadvantages of these products.
Client Name: Client Signature: Date:
Spouse’s / Civil Partner’s Signature
I confi rm that I have been fully made aware of the associated advantages and potential disadvantages of these products.
Client Name: Client Signature: Date:
For more information concerning the details contained in this guide, please speak to your
independent financial adviser. You can find our contact details are on the back cover.
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