Drawdown Phase

DRAWDOWN / INCOME PENSION

A Drawdown Pension allows you to take income from your pension fund while the fund remains invested and continues to benefit from any fund growth. You generally need a fund value of around £100,000 to take the drawdown/ income drawdown option.

WHAT IS A DRAWDOWN/INCOME DRAWDOWN PENSION?

There are two types of drawdown pension;

• Capped Drawdown
• Flexible Drawdown

You can only enter into drawdown if you have a defined contribution / personal pension product.

Prior to the Finance Act 2011 drawdown was commonly known as an unsecured pension also known as income drawdown.

New Income Drawdown rules were introduced from 6 April 2011. If you started an Income Drawdown plan before 6 April 2011, you will not have to convert to the new rules straight away.

WHAT ARE THE PRE 6 APRIL 2011 INCOME DRAWDOWN RULES?

• There was not a requirement to draw an income.
• The maximum amount which may be drawn was 120% of the single life annuity that somebody of the same sex and age could purchase based on Government Actuary’s Department (GAD) rates.
• The maximum amount was reviewed every five years until age 75.

Although the maximum amount was generally reviewed every five years until age 75, there are certain events when the maximum amount has to be reviewed earlier than this. These events are:

• If part of the fund is used to buy an annuity.
• The fund is increased or reduced on pension sharing on divorce
• An income drawdown contract accepts a transfer of funds from another income drawdown contract or further funds are set aside for drawdown.

An individual could have asked their pension provider to start a new five year review period (up to age 75) before their existing five year period ended. Any new five year period started at the next anniversary date of the current five year period. The pension provider did not have to agree to this. Any new five year period had to be in place before the proposed new rules come into force on 6 April 2011.

WHAT ARE THE NEW DRAWDOWN/INCOME DRAWDOWN RULES?

A summary of the new Drawdown rules are as follows:

• There is no minimum amount of income that you must take, irrespective of age
• The maximum amount of income you can take has reduced from 120% to 100% of the single life annuity that a person of the same gender and age could purchase based on Government Actuary’s Department (GAD) rates
• The maximum amount will now be reviewed every 3 years (unless an event occurs) until age 75. Annual reviews will take place from age 75
• Tax free cash /pension commencement lump sums may now be paid after age 75
• Flexible drawdown introduced with the option to take unlimited withdrawals if you already have a secure pension income of £20,000

HOW IS THE MAXIMUM DRAWDOWN/INCOME DRAWDOWN PAYMENT CALCULATED?

1. Take your age at the date the drawdown pension becomes effective
2. Find the gross redemption yield on UK gilts from the FTSE – Actuaries Government Securities Yield Indices which is published daily in the Financial Times. The gilt yield figure will be the 15th day of the month prior to the drawdown effective date. For example if the drawdown effective date was 1 September the gilt yield date would be 15 August which would be published in the Financial Times 16 August
3. The yield must be an exact multiple of 0.25%, if it isn’t you will need to round it down the next 0.25%
4. You must then look up what the maximum withdrawal rate is via the HMRC Gad Table www.hmrc.gov.uk/pensionschemes/gad-tables.htm

An example is as follows;

John is aged 60 and designates £200,000 of his personal pension fund to capped drawdown. He takes his maximum PCLS of £50,000 (25% x £200,000) and designates the balance of £150,000. The current gilt yield (based on figures as at 15 May 2012) is 2.42%.

The current gilt yield (as at May 2012) is rounded down to 2.25%, which shows a figure of £48 per thousand pound of fund.

The maximum income John can draw is £7,200 a year (£48/£1000 x £150,000). Income payments are paid net of tax.

WHAT HAPPENS AT THE DRAWDOWN/INCOME DRAWDOWN REVIEW?

HM Revenue and Customs (HMRC) sets out minimum and maximum amounts that can be withdrawn and a review of these amounts are important because you need to have sufficient retirement funds available when you decide to purchase an annuity. With drawdown/income drawdown a considerable amount of on going advice is required to determine when and how benefits should be drawn.

The first benefit crystallisation (BCE) date sets the pension years for the remainder of the policy’s lifetime. If you crystallise some or the entire plan at outset the pension years will coincide with the policy anniversaries.

Income limits on an income drawdown plan must be reviewed at the end of each reference period. Under the new rules a reference period currently lasts 3 pension years.
If you were in a drawdown arrangement prior to the 6 April 2011, the transitional rules are as follows:

• If you are under 75 you can continue to draw income based on the previous maximum limit of 120% until the end of your current five year review period. When this review period ceases it will be reviewed every three years.
• If you are age 75 or over you can continue to draw income based on the previous minimum and maximum limits until the start of your next review. When this review period ceases it will be reviewed annually.

CAN MY DRAWDOWN/INCOME DRAWDOWN LIMIT BE REVIEWED BEFORE THE REFERENCE PERIOD?

Yes the following events can trigger another review before the reference period:

• If further monies are crystallised in the plan.
• If you purchase an annuity with part of your pension plan.
• If the fund is reduced as the result of a pension sharing order.

In each of these cases, the new income limit must be calculated on the day the action takes place. However, it will not apply until the end of the scheme year.

WHAT IS FLEXIBLE DRAWDOWN?

The new rule on drawdown (subject to terms and conditions) allows you to take as little or as much income as you want from your fund on retirement.
The rules are as follows:

• You must have a secure pension income of at least £20,000 a year
• You will need to complete a declaration that you meet the requirements and you have not contributed into your retirement fund in the tax year the declaration is signed

If you make additional retirement contributions in future tax years you will be subject to an annual allowance charge. Please note you cannot carry forward unused relief for this event.

WHAT IS SECURE PENSION INCOME?

A secure pension income is any of the following:

• When you receive a secure income from a UK pension scheme pension that has 20 or more people receiving a retirement income
• When you receive a secure pension income from an overseas scheme pension
• When you receive a secure income from an annuity/scheme pension such as a private pension or defined contribution scheme either from the UK or from overseas.
• When a dependent’s pension/annuity is paid to you either from the UK or from overseas
• When a state pension is paid to you either from the UK or from overseas
• When payments are received from the Financial Assistance Scheme

Income from a drawdown pension is not classed as secure pension income.

WHAT IS A SHORT-TERM ANNUITY?

Once in drawdown you could consider a short term annuity.

A short term annuity is an arrangement made between you and an insurance company of your choice. You pay part of your fund and in return the insurance company pays you an income for a fixed period of up to 5 years.

The maximum amount that can be paid is calculated by taking the rate from the government actuaries’ department (GAD) table.

This maximum amount must be recalculated every three years. The annuity can be level or it can be arranged to increase each year at a fixed rate or in line with the Retail Price Index (RPI).

WHAT ARE THE DEATH BENEFITS WHILST IN DRAWDOWN/INCOME DRAWDOWN?

In the event of death during drawdown, any surviving spouse or nominated dependants will have the following options:

• Receive a cash lump sum, after an income tax deduction of 55%.
• Purchase a conventional annuity
• Continue with drawing an income from the fund. Income levels will be reset based on the survivor’s age and the government actuarial rates applying at that time. It cannot exceed the level of income the policy holder could have received had they purchased an annuity immediately prior to death.
• If the drawdown option is chosen, the survivor may change their mind and take the cash lump sum subject again to the 55% tax charge

Inheritance Tax

Subject to terms and conditions Inheritance Tax no longer applies to pensions.

Inheritance Tax may be charged in the following instances:

• When the pension scheme trustees have no discretion to who will benefit
• If an event occurs or the lump sum death benefit is accelerated within 2 years of death, e.g. if you are ill and pay contribution in excess of what would have normally been paid, transferring the pension, reducing the income payments whilst in drawdown or making a nomination of who should receive the lump sum death benefit.

WHAT ARE THE ADVANTAGES AND DISADVANTAGES OF DRAWDOWN/INCOME DRAWDOWN?

Advantages:

• You can immediately access your tax-free cash lump sum, without having to take an income
• If you think annuity rates are low and may improve by the time you wish to purchase an annuity
• You gain flexibility and control over the amount and timing of the income you draw. The income from an annuity is fixed and may not suit your personal circumstances- you may still be working or you may have income from other sources.
• This flexibility of income can allow you to mitigate your income tax amounts and allow you to take full advantage of age allowance which increases from the age of 65 and again at 75.
• You may benefit from fund performance which, potentially, could mean your invested funds grow considerably.
• The death benefits are more generous than other retirement vehicles and there is more choice for the beneficiaries if you were to die whilst being in Drawdown.

Disadvantages:

• The charges/costs involved are higher than an annuity
• Withdrawing too much income in early years may have an adverse effect on preserving your pension purchasing power or preserving the capital value of your fund.
• You will need to review your Drawdown arrangement by placing the funds under on-going monitoring and supervision.
• You should review performance at least once a year and make changes to asset allocation in accordance with your attitude to investment risk.

WHAT ARE THE RISKS OF USING DRAWDOWN/INCOME DRAWDOWN?

The risks involved are as follows:

• High-income withdrawals may not be sustainable during the deferral period. High withdrawals may erode the capital value of the fund, especially if investment returns are poor. This may result in a lower income when an annuity is eventually purchased.
• The investment returns may be lower than anticipated.
• Annuity rates may be lower when you purchase an annuity
• By purchasing an annuity you may benefit from a cross subsidy from those annuitants who die early. This cross subsidy is not present with drawdown and so to provide a comparable income, a higher investment return will be required (the critical yield). This effect is known as mortality drag.
• The charges from a drawdown plan will be higher than those under a conventional annuity due to the complexity of the contract and the on going need for advice and active investment. This may reduce the value of the fund available to provide an income.

WHAT IS MY ATTITUDE TO RISK?

In constructing your portfolio it is important that you understand the risks associated with the investments that are chosen.

WHAT DO WE MEAN BY RISK?

Risk and uncertainty are different. The possibility that things may not turn out exactly as you expected is uncertainty. Risk, to some may mean the possibility of losing a portion of your capital. For others, the risk of their capital not producing enough income on which to live may dominate their concerns.
Risk and uncertainty cannot be eliminated. However they can be measured and managed within your portfolio. The key is to determine the appropriate level of risk for you. Taking on greater uncertainty and short term risk may be necessary for you to gain the long term returns needed to achieve your lifestyle goals and objectives.

HOW DO YOU COPE WITH RISK?

In considering an investment strategy, you need to understand the risks that you may be exposed to and how they will impact your personal situation. Assessing risk and potential investment return should be in the context of your goals and the time you have to achieve your investment objectives.

YOUR INVESTMENT PROFILE

An integral part of developing your investment strategies involves determining your attitude to investment risk. It has a direct impact on the likely returns of your investments. We call this your investment risk profile.
To help determine your investment risk profile, please complete the following questionnaire

CAN I TRANSFER MY FUNDS WHILST IN DRAWDOWN?

Yes, you can transfer an income drawdown plan to another income drawdown provider.
The rules are as follows:

• It must be transferred to another drawdown arrangement and held in a separate arrangement in which no other assets are invested
• The receiving scheme must adopt the same drawdown pension year

HMRC regulations do not permit partial transfer of income drawdown arrangements, so all of the funds must normally be transferred at the same time to the same provider

RECYCLING OF TAX FREE LUMP SUMS

If you choose to take a tax free lump sum (pension commencement lump sum) you need to be aware there are HMRC rules in place to prevent you from “recycling” the tax free lump sum back into a pension.

Put into context this means using a tax free lump sum which you have received or expect to receive and reinvesting it back into a pension to gain additional tax relief.

WHEN DO THE RECYCLING RULES APPLY?

The recycling rule applies when all of the following conditions are met:

• You received a tax free lump sum/pension commencement lump sum.
• If the value of the lump sum plus any other tax free lump sums taken in the previous 12 months exceeds 1% of the standard lifetime allowance (eg; £15,000 during 2012/13 tax year).
• If you have significantly increased your pension contributions in the preceding and following two tax years. HMRC deem an increase of 30% or more to the value of pension contributions as significant.
• The preceding and following two tax years are treated in isolation when calculating the percentage increase. The percentages are then combined to assess if it has exceeded 30%.
• You or someone on your behalf makes a conscious decision to take the tax free lump sum and re invest it back into a pension fund.

The following link to the HMRC website gives a comprehensive overview of the rules www.hmrc.gov.uk/manuals/rpsmmanual/rpsm04104920.htm and highlights the scenarios on when the rule does not apply.

THIRD WAY ANNUITY

In recent times a ‘third option’ or ‘third way’ has been developed – a ‘protected’ approach which offers protection against falling stock markets by using what are known as ‘unit-linked guarantees’.

These are not to be confused with structured products the like of which the failed Lehman Brothers was a major contributor. These guarantees have proved popular in both Japan and the US and are now building market share in the UK. There is a possibility that they will increasingly become a part of mainstream retirement planning, as unstable market conditions increase the attractions of guarantees.

This new approach makes it possible to try to achieve higher potential returns from stock markets, but at the same time protect against large losses. If you have plenty of other secure income for your retirement, you may not need to worry about whether or not your pension does well, however if you do not have much else to rely on then you may be attracted to the idea of protection.

These guarantees should give a return - on average – above the returns on risk free assets (UK Government gilts) and below those of equities without any protection, however, you will still have the opportunity to benefit from strong markets – while simultaneously insuring yourself against the loss of money if the markets do not do well. Of course, the very sharp falls suffered by equity markets in recent months may have led you to think that equities have significant upside potential.

If you are convinced that the stock market has to go up and cannot fall much, then you may feel confident enough to take the risk and wait for it to work for you. However, if you are not totally sure or simply cannot afford to get it wrong, then you may want to consider third way solutions. In reality, there are no guarantees that the stock market will rise strongly. If the economy fails to recover, or the UK experiences a repeat of the Japanese experience, there could also be much more downside risk even from current levels. This means that you may be partial to keeping your money in the stock market, but you may also consider these protected products.