When you come to retire, you have two options: you can either buy an annuity, or you can defer buying an annuity by taking what is called an "unsecured pension."
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Unsecured pension (pension drawdown)
This involves you taking up to 25 per cent of your fund as tax free cash, and leaving the remainder of your pension fund invested. In the meantime, you can take income as and when you need it from the fund, subject to certain Inland Revenue limits, but you are not obliged to take income each year. If you want, you can choose to take no income at all for as long as you like until age 75 when you are obliged to either buy an annuity or transfer the fund to an Alternatively Secured Pension or ASP.
The minimum income you can take from an unsecured pension is zero and the maximum is roughly 120 per cent of what a single, level annuity would pay someone of your age. Unsecured pensions replaced "income drawdown" when the new rules for pension simplification came into force on 6 April 2006.
The advantages of taking an unsecured pension
Taking an unsecured pension has a number of advantages including:
- income flexibility - each year the amount of income taken can be varied between the minimum and maximum limits. Income can also be taken monthly, quarterly, half yearly or annually.
- control over your investments - if the unsecured pension is set up through a self invested personal pension or Sipp, there is a wide range of investment options available.
- choice of death benefits - unlike annuities where the only death benefits available are from a joint life, guaranteed, or money back annuity, drawdown offers a choice of death benefits.
The disadvantages
When you buy an annuity, you give up control of your pension fund in return for a secure income. With an unsecured pension, you maintain control of the pension fund but your income will not be secure, so it is a much more risky option than buying an annuity.
There are a number of risks involved when you defer an annuity purchase by investing in an income drawdown plan. Understanding and knowing how to manage these risks is very important.
- Investment risk – the value of your investments can go down as well as up.
- Mortality drag - if you defer purchasing an annuity, you will miss out on the mortality cross subsidy. The extra return required to compensate for the absence of this subsidy is called mortality drag.
- Decrease in your annuity purchasing power – If annuity rates fall and the value of your pension fund does not increase sufficiently to compensate, an annuity purchased in later years will provide less income compared to purchasing an annuity now.
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Income limits
The amount of income that can be paid from an Unsecured Pension fund is determined by reference to tables produced by the Government Actuary's Department (GAD). The maximum income in any one year is roughly equal to 120 per cent of what a level, single life annuity would pay someone of your age, while there is no minimum income requirement. This means that you can choose to take no income each year if you so wish.
To ensure that the income limits from drawdown are in line with annuities, the limits are calculated by reference to current gilt yields. GAD produces a set of special tables based on a range of interest rates.
Income Flexibility
Income can be varied each year so long as it is kept within the GAD limits. Income withdrawals can be paid monthly, quarterly, half yearly or annually and can be in advance or arrears.
Five-yearly reviews
There is a compulsory review of unsecured pension arrangements every five years to ensure that the pension fund can sustain future income payments. At the review, the minimum and maximum income limits are set for the next five years.
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Short-term annuity
Tax simplification introduced a new option whereby an individual may choose to secure part (or all) of their unsecured pension through the purchase of a short-term annuity contract from an insurance company. The term of that annuity contract cannot be more than five years, and the annual amount payable by the contract is bound by the same rules as income withdrawal payments paid direct from the scheme. The term of that annuity must not extend beyond the member's 75th birthday.
The short-term annuity contract option gives people the opportunity to reassess their pension needs periodically and to choose alternative types of annuities, so long as they secure an income for life by age 75.
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Drawdown - death benefits
For many people, the more flexible death benefits are the most attractive feature of drawdown. Conversely, the most negative part of an annuity is the absence of any lump death benefit (unless you have purchased a joint life, guaranteed or money back annuity).
On the death of the policyholder before age 75 there are three options:
- Take a lump sum death benefit - a surviving spouse or dependant may take the remaining pension fund as a capital sum, less a 35 per cent tax charge. The lump sum payment will be free of IHT, providing the correct trust has been set up.
- Continued taking unsecured pension - a surviving spouse or dependant may continue taking income withdrawals.
- Annuity purchase - a single life annuity can be purchased for the spouse or dependant.
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Alternatively Secured Pension (ASP)
ASP is a new option that allows you to avoid purchasing an annuity at the age of 75 by continuing with a limited form of unsecured pension. For many years, the government and the Revenue resisted pressure to abolish the compulsion to buy annuities at age 75. They argued that pensions are designed to provide income in retirement and should not be used to allow individuals to pass their pension funds to their families.
Therefore, it was a welcome surprise when as part of pension simplification in 2006, that the government introduced this new option. However, the attractiveness of ASP was greatly reduced when, in December 2006, the rules were changed so that the option to leave unused ASP funds to the family will attract an effective tax charge of over 80 per cent.
Income Limits
Alternatively Secured Pension or ASP will be paid to an individual from their pension fund in much the same way as for an unsecured pension before age 75. The maximum permitted income is roughly equivalent to 90 per cent of what a single life, level annuity would pay to someone aged 75. The minimum income will be 55 per cent, also based on what a single, level annuity would pay to someone age 75, but as you grow older, the maximum income will still be based on the equivalent annuity payment for someone aged 75.
The income limits are reviewed every year and the amount of income you take within these limits can be changed each year, providing you do not exceed the maximum.
Death benefits
On death, any remaining ASP funds must be used to provide benefits for any surviving dependants. Your spouse or partner will be considered a dependant, as will children under the age of 23, who are in full time education. Benefits paid to dependants must be in the form of income and there is no lump sum death benefit for dependants.
Income can be paid as:
- a lifetime annuity
- an unsecured pension, if the dependant is under the age of 75
- or ASP, if the dependant is over age 75
If there are no living dependants, the remaining funds can be paid as a lump sum death benefit. The payment will be:
- tax free, if paid to a charity of your choice; but
- any payments to individuals, or transfers to other pension funds, will be treated as "unauthorised" payments. Any such payments will incur a tax charge as high as 82 per cent (which is made up of a combination of 70 per cent tax on the pension fund and 40 per cent inheritance tax thereafter).
Phased Retirement
This is a very tax efficient way to take your pension income. Your pension plan is set up with a number of different segments and each year you convert a number of these segments into tax free cash and an income bought via a mini annuity.Each vested segment is taken as tax-free cash (normally 25 per cent) and the remainder as a mini annuity. The tax-free cash is added to the annuity and the two together provide income for that year. As a large part of the total annual income comprises tax-free cash, it is clearly very tax efficient as income tax is only applied to the annuity.
In subsequent years, further encashments are made to provide more tax-free cash and income, in addition to the annuities already in payment. Therefore, there will be a number of different annuities and each one could be purchased on a different basis - for instance, with profits, single or joint life, level or escalating. On death of the policyholder before age 75, any unvested pensions segments will be paid out free of tax. In addition, there may be ongoing payment from the annuities already in payment, such as from the balance of any guaranteed period and or a spouse's pension.
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Deciding between an annuity and Unsecured Income
Deciding between an annuity and pension drawdown can be a very difficult decision because there are many different factors to take into consideration. As you approach retirement, it is important to set out your retirement objectives. As you do this, you will realise that you probably have more than one objective and there is no one type of annuity or drawdown that will meet all of these objectives.
This is why it may be in your interests to mix and match your pension fund by splitting it up and using part of the fund to buy a mix of annuities and using the remainder to take an unsecured pension or ASP, depending on your age.
The table below sets out the some of the most important objectives with a comment about which product meets these objectives.
| Objective |
Comment |
| Sustainable income for the rest of your life |
Few people want a falling income and the only sure way to guarantee an income is with an annuity. Only annuities can insure against longevity because they are based on the concept of mortality cross subsidy. |
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With drawdown (unsecured pension or ASP), there is a significant risk that income levels may reduce in the future because there is no mortality cross subsidy and you might not achieve the required investment returns. However, drawdown does provide the opportunity to outperform an annuity and there is more flexibility |
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| Keeping place with inflation |
Inflation reduces the future value of your income. Level annuities may be storing up trouble for the future if high inflation returns, but inflation linked annuities are expensive |
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Only an index linked annuity can guarantee to maintain its real value over time. |
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For those who believe that in the long run, equities are a good hedge against inflation, a with profit or unit linked annuity could be considered instead of an index linked annuity. |
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A drawdown (unsecured pensions or ASP plan) with the appropriate investment strategy should be able to provide an income stream that at least keeps pace with inflation |
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| Flexibility |
There is no flexibility with a standard annuity but the income is guaranteed |
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flexible annuities provide a certain amount of flexibility with income levels and control over your investments |
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drawdown (unsecured pensions and ASP) provide flexible income options, investment control and choice of death benefits. However flexibility comes with a price, the risk of a lower income in the future. |
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| Financial Security for family |
Most annuities do not provide a lump sum death benefit, unless they have been set up with a spouse's pension and/or a minimum guarantee period. |
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The open annuity provides a lump sum death benefit |
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Drawdown (unsecured pensions) provide better death benefits by allowing a lump sum death benefit (less 35 per cent tax) to be paid (if the plan holder dies before age 75) or continued income for spouse and or dependants |
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Even better death benefits are available with phased retirement |
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| Not taking undue risk |
The main risks to consider in retirement are: the risk of income falling, inflation risk, investment risk and the risk that your circumstances may change. No one policy can manage all these risks, which means that even an annuity is not risk free. Understanding and managing risk is one the most important aspects of retirement planning and those who are risk averse will probably be more comfortable with an annuity. |
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Those prepared to take a certain amount of risk, in return for the extra flexibility and control, will be attracted to drawdown |
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For those who are not risk averse, but do want to take all the risks associated with pension drawdown, with profit annuities may be considered |
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