What are your options at retirement?
If you have a “money purchase” pension (a pot of money), such as a Personal Pension, Stakeholder Pension, Self-Invested Personal Pension (SIPP) or an Additional Voluntary Contribution (AVC) you will need to make decisions on how you convert the fund into income or cash, which we describe below in more detail.
If you have a “defined benefit” pension or “scheme pension” this will be based on a promise of benefits from your employer and you will not normally need to consider many options, other than those that are given by the scheme. The changes that the Government has made to pensions in the 2014 Budget do not apply to Defined benefit or scheme pensions.
Prior to the new Pension changes pension defined contribution pension members over age 55 could take 25% of their fund value as tax free cash and the balance (75%) of the fund was required to be taken as income (with limitations) in the following formats:
• Lifetime annuity
• Income drawdown
• Flexible drawdown
• Phased retirement
• Fixed term annuity
• Investment-linked annuity
• A combination of the above
• Small pension funds could be taken as taxable cash
These options are described in detail below.
What are the pension formats available under the current rules?
This option is considered the safest option for those who want to have a guaranteed income for life.
A conventional lifetime annuity is the transfer of the fund value to an insurance company, in return for a guaranteed income for life.
This means that the insurance company retains the investment risk for the promise of the income that they make.
Insurance companies offer different annuity rates, which means that it is important to look for the best annuity provider for your circumstances.
The “Open Market Option” is a legal right that allows you to buy an annuity from any annuity provider, rather than the pension provider that you saved with. An open market option could mean an improved income of as much as 30% and will take into account your age, health and lifestyle.
Options when you set up an annuity
Most people are confused by the word annuity but it simply means an income.
When you set up an annuity you have to make certain decisions which will make the income higher or lower at the outset such as:-
• Whether to approach an insurer who will take account of medical conditions or lifestyle.
• Select an annuity that stops on your death.
• Select and annuity that continues to pay an income to a spouse on your death, you can select any level of income to continue to be paid to your spouse.
• Select an income which stays the same or which increasing each year to keep pace with inflation.
• Select an income which guarantees to pay for 5 or 10 years even if you dies before then.
• Select a protected annuity (money back option)
Other than the above type of guarantees an annuity ends on death and the fund is spent and cannot be passed to dependants.
Fixed term annuities
Pay a fixed income for a set term rather than for life, and provide you with a maturity lump sum at the end of the term. You may then buy another fixed term annuity, a lifetime annuity or go into drawdown.
Short term annuities can delay making a long term decision which could be beneficial if annuity rates rise in future, or detrimental if annuity rates drop in future.
You usually need to decide at the start of a fixed term annuity what would happen on your death during the term, whether an income could continue to be paid or a lump sum paid.
Income drawdown allows you to take the tax free cash and leave the rest of your fund invested from which you can elect to draw an income which is subject to limits set by the government. You do not have to take any income from the remaining fund if you do not want or need income.
Income drawdown is a higher risk option than an annuity because the remaining fund is your responsibility and the investment risk is yours. The fund can rise and fall and will need monitoring especially if income is being taken from the fund. If a high level of income is being taken from the fund and the fund performance is poor the fund value and the available income is likely to reduce.
The main benefit of income drawdown is that on death the fund can be passed to a spouse who can continue to use the remaining fund for income drawdown or to purchase an annuity or the fund can be passed to beneficiaries, less a 55% tax charge.
Flexible drawdown is the same as income drawdown without the government set income limits.
To qualify for flexible drawdown you must already have £12,000 per year of pension income in payment from either your state pension, a pension annuity or a company pension scheme.
You must not have made any pension contributions in the tax year that you start flexible drawdown and no further tax relieved pension contributions will be allowed in future.
Phased or partial retirement
Pension funds where tax free cash and/or income has been taken are call crystallised pensions and that where no tax free cash or income has yet been taken are call uncrystallised pensions.
Uncrystallised pensions funds are returned to the owners tax free if the owner dies. This aspect is therefore considered to be an important death benefit of pensions.
Phased or partial retirement uses the basic principle of income drawdown but rather than converting your entire pension by taking the full 25% tax free cash, it may be beneficial to convert only a proportion of the fund at a time, into the actual income required each year, over a number of years, therefore maintaining a higher level of death benefits.
Phased or Partial retirement allows you to do this by calculating the amount of income required and using a combination of the tax free cash and income equal to the amount of income required. The use of the tax free cash as income is tax efficient for income.
Investment-linked annuities and variable annuities
Unlike conventional annuities which are secure, investment-linked annuities depend on the performance of an underlying investment. They are designed to allow a potentially increasing income but there is an element of investment risk as the investment will be reliant on stock market returns and there is a chance income could fall as well as rise.
These types of annuity can be complicated and are generally not very transparent.
Small pension pots
If you are over 60 and either have total pension savings worth up to £30,000 or upto 3 individual pension pots worth up to £10,000 you may be able to take your entire pension as cash. This would be in the form of 25% tax free and the remaining balance as taxable income for the tax year of receipt.
The full state pension for tax year 2014/15 is £113.10 per week for a single person and £180.90 for a married couple.
If you have been employed and contracted into the State Second Pension (S2P) or the State Earnings Related Pension Scheme (SERPS) you will receive an Additional State Pension.
After 6 April 2016 you will receive the new proposed single tier, flat rate pension, which is expected to be about £150 per week.
You can find out more about your state pension by contacting the Department for Work and Pensions: www.gov.uk/state-pension
or call them on 0345 606 0265.
New Pension Rules.
• From April 2015 the new rules will allow you to take 25% tax free and unlimited income from the balance of the fund but you will have to pay income tax as if this was added to your earned income for that tax year.
• The 55% tax charge currently levied on lump sums from crystallised pension funds in drawdown or on uncrystallised funds after age 75 is currently being reviewed but is expected to come in line with income tax rules or Inheritance tax rules.
• The Normal Minimum Pension age at which an individual can take their private pension savings will increase from 55 to 57 in 2028, at the point that the State Pension age increases to 67.
• Once the flexibility rules are taken the individuals annual allowance will reduce to £10,000 per year.
If you intend to draw all your pension fund as income you need to consider how much tax will be payable and whether drawing income over several tax years would be more tax efficient.
You also need to consider that your retirement could last decades and your income in retirement will be less if you spend your pension fund rather than taking it as income from your pension or re-investing it elsewhere for an equitable income.
The lifetime allowance
The value of all your pension savings are subject to a lifetime allowance of £1.25M (2014/15)
Any funds over this amount could be subject to a 55% tax charge.
To value your pension funds:
1/ For defined contribution pensions use the current fund value.
2/ For defined benefit final salary schemes, multiply the current accrued annual pension, not yet in payment, by X20 plus any additional tax-free cash entitlement.
3/ Any pensions in payment before 6th April 2006 multiply the annual income by X25.
State benefits are not included in the calculation.
Risk Warnings for Pension Withdrawal.
• Past performance is not a guide to future performance.
• Investment returns may be less than shown in illustrations.
• Investments can fall as well as rise and you could get back less than you invested.
• Benefits from an annuity or drawdown plan can reduce some means tested benefits.
• Pension and tax legislation is subject to government changes.
• Once an annuity is set up you cannot normally cancel it.
• Annuity rates may reduce during the purchase period.
• Income Drawdown – high income withdrawals may not be sustainable, withdrawals may erode the capital value of the pension fund, especially if investment returns are poor which could result in a lower income if an annuity is ultimately purchased.
• Future contribution allowances may be reduced