Pension Income Drawdown

July 01, 2011

Traditionally, Contractors nearing retirement draw 25% of their pension fund as tax free cash but are then forced to purchase an annuity with the remaining money that they have built up in their pension pot... Annuities are provided by insurance companies and offer a guaranteed income for the rest of your life based on the value of your pension pot when you retire. The insurer will judge that you are statistically likely to live to a certain age and commits to provide a set income that reflects this calculation. In practice they use some of the money they make from those short lived annuity clients to inflate the income they can afford to pay out to the rest so you are, in effect, gambling that you live long enough to receive a greater sum than you've paid over to the insurer. This is because whereas if you die before you start drawing an income from your pension the fund will pass to your dependents, after retirement the annuity provider pockets the unused cash. Income drawdown offers a flexible alternative to the annuity option however as it allows you to keep your pension fund invested whilst you draw an income. This could mean that your nest egg and the income it produces can continue to grow and under the new rules introduced in April this year; you have even greater say over how your retirement income is managed. Income drawdown now follows these guidelines:

  • As an alternative to taking a tax free lump sum between ages 55 and 75, under the revised rules, you are able to benefit from a tax free withdrawal after age 75 as long as you have designated funds to this purpose. This offers far greater flexibility and allows you to save your lump sum drawdown for a time that suits you.
  • Whatever your age in retirement, you can now decide how much of your fund you take as income as there is no minimum amount anymore. This allows Contractors that carry on working to leave your pension untouched until you are ready to fully retire.
  • In an attempt to protect Contractors from spending their entire retirement fund and then being forced to rely on the state in later years, the maximum amount that you can draw has also changed. Your income drawdown allowance will be calculated by your pension provider so that you can't release more than 100% of the equivalent annuity for someone of the same sex and age as outlined by the Governments Actuary Department (GAD).
  • The maximum amount that you can draw needs to be regularly reviewed to ensure that your plan remains on track. Under the new rules, your income will be reviewed against the maximum annuity every three years until you reach age 75 and then every year thereafter.

These new rules will help an ever greater number of Contractors to enjoy the flexibility of income drawdown as it is increasingly no longer just limited to those with the largest pension pots. However, it is important to bear in mind that there is a risk associated with leaving your pension invested as it may be susceptible to volatility in, for instance, the stock market. In order to lower the risk associated with these fluctuations, you could look to draw income from less risky assets such as cash and leave equity funds to benefit from long term growth. Crucially though, unlike the money used to buy an annuity that does not form part of your estate when you die, pensioners in drawdown pass on their fund to dependents minus a tax charge. In this way the pension can be used to pass funds down through the generations.

Phased income drawdown

If you are even more concerned about what will happen to your pension pot when you pass away then phased income drawdown may be an even better option for you. It is ideally suited to Contractors aged under 75 who don't have a need for the full tax free lump sum as phased drawdown enables you to release less income now so that your dependents are entitled to more of your pension when you die. Your dependents will receive more of your pension fund because you only move part of your fund into a drawdown plan; the rest remains invested in a personal pension which is protected in trust. Any money left untouched in the personal pension when you die will be paid as a lump sum to your dependents without any inheritance tax being taken and the tax charge only falls upon the money in drawdown so it provides a very tax efficient way of transferring savings to your loved ones.

Flexible drawdown

Enables those with a minimum £20k pa income from a scheme such as the civil service pension etc to then draw the money as cash lump sums from any additional pension pots they may have. Subject to a tax charge this is a means of retirees unlocking potentially massive sums from the rigid constraint of a pension but in reality it is sadly rare for Contractors to have the guaranteed £20k income from a suitably guaranteed source.

A flexible pension

If you opt for income drawdown when you retire then you will enjoy far more flexibility than your peers with an annuity but the good news is that you can always change your plans if you no longer wish to manage your own retirement fund. Contractors can switch to an annuity arrangement at any time if you feel that you would prefer to have a set income for the rest of your life. However, you will need to bear in mind that if you buy an annuity at a later stage, you may then have less in your pot to purchase one than if you buy one at age 65. Paradoxically annuity rates may also get progressively worse as you get older due to something known as mortality drag where the bean counters judge you to be more likely to reach very old age and also have less unspent money from those other savers who have died early. It is important to consider how you will manage your income and whether or not you will carry on working past retirement age when deciding on whether to opt for income drawdown. It can be difficult to determine the best route to suit your individual circumstances but the specialist pension advisers at ContractorFinancials are on hand to help. To speak to Andrew Gains or Catherine Young about your retirement planning call0333 370 8888 or email pensions@contractorfinancials.com.