Drawdown

What is Drawdown?

Until 1995, a policyholder who retired when annuity rates were low, would end up with a smaller pension than could have been obtained from the same fund had he been able to postpone the purchase until annuity rates were more favourable. The Finance Act 1995 introduced the income withdrawal facility. This enables a policyholder to make withdrawals from their pension fund, which are treated as income, and defer purchase of the annuity until later when annuity rates might be more favourable.

How does Drawdown work?

On electing for income drawdown you may take a proportion of your accumulated fund as a tax-free cash sum. This will be up to a maximum of 25% of the fund.

Income will then be paid from the fund. There are legal limits to the amount of income that can be received, between 0% and 120% of an amount determined by the Government Actuary. The minimum income is 0% of the maximum. The annual amount withdrawn must be between these limits, but can be varied each year.

Withdrawals are taxable in full under PAYE in the same way as a conventional annuity. Investment income and Capital Gains within the fund retain the same beneficial tax treatment as they had before drawdown commenced.

Income Drawdown

With an income drawdown arrangement, you can choose to immediately take up to 25% of your fund as a tax-free cash lump sum. Instead of buying an annuity with the remainder of the fund, the remaining funds stay invested and you draw your income directly from the fund. These invested funds can benefit from investment performance in a tax-efficient environment.

An income can be taken from your invested pension fund each year which will be taxed as earned income. This income may vary between limits which are set when you first take out the option. These limits are discussed later in the report. Now that "A Day" has arrived, compulsion to purchase an annuity at age 75 has been abolished. Instead, Drawdown schemes become an "Actively Secured Pension". You can continue to draw an income directly from the fund, but the limits for flexibility of income is more restrictive. The maximum income you can take from an ASP is 90% of GAD rates. These will be based on annuity rates for a 75 year old. The minimum income you can take from an ASP is 55% per annum.

In addition, if your beneficiaries chose to receive the lump sum death benefits from an ASP, this could be less generous- return of fund which is subject to inheritance tax if your Estate is valued at more than the "Nil Rate Band". The Nil Rate Band - the amount that your Estate can pass onto beneficiaries without being subject to Inheritance Tax (currently at 40%), which in the 2008/9 tax year is £312,000.

Investment management

As the rest of your pension fund remains invested in a tax-efficient environment, your final pension - and the income limits you withdraw each year - will be determined by the continued investment management of your funds. Careful attention therefore needs to be given to the investment management of your pension funds during income drawdown to ensure that when you finally buy an annuity you are in a no worse-off situation than if you had bought an annuity at the start.

Income management

You are able to vary your income within set limits each year; the maximum of which is equal to 120% of a conventional annuity. The level of income you choose to take will have implications for the performance of your invested fund, and will influence future possible levels of annuity you can buy.

It is important that you balance your income requirements with the investment policy to ensure the annuity purchasing power of your pension fund is maintained. The effect of withdrawals will be considered later in the report.

Annuity purchase management

Income drawdown defers the purchase of an annuity until a more appropriate time when either personal or economic circumstances are more suitable.

What happens if you die?

If you die whilst you are in income drawdown before the age of 75 your nominated survivors can take the remaining value of the arrangements as a lump sum, after a tax deduction (which is currently 35%).

However, after the age of 75, the only death benefit options become more complicated. You could leave the fund to a registered charity or political party if you have no surviving spouse or dependant.

Alternatively, you could set up a transfer lump sum death benefit to a member of the same scheme. The way to effect this is to ensure that the nominated beneficiaries take out a personal pension with the Life Office. Provided the contract is with the same scheme, this would allow the funds to be transferred on death. If the beneficiaries are over 75, they would need to be members of an ASP with the same scheme.

Mortality Drag

The price of an annuity is based on the life expectancy of the annuitant when the annuity is started. Some annuitants will live longer than others and receive more in payments than they have put into the fund plus interest. Others will not even get their initial premium back in income. This is called the mortality factor.

Those deferring an annuity purchase receive less mortality drag benefit due to changing life expectancy. Investments in pension drawdown schemes or phased retirement arrangements need to earn additional returns simply to match the mortality benefit. In the view of the Financial Services Authority, the additional return required at age 60 is about 1% a year and by age 75 it may be about 4% a year for an individual taking a maximum 120% withdrawal.

Advantages and disadvantages of Income Drawdown:

Advantages:

• You can immediately access your tax-free cash lump sum, without necessarily having to take an income until you need to.
• You can gain flexibility and control over the amount and timing of the income you draw. The income from an annuity is fixed and this may not suit your personal circumstances- you may still be working or looking to reduce your working hours gradually, 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, but can be reduced to nothing if your income is too large.
• You can 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:

• A prudent and well diversified investment portfolio needs to be decided upon which will involve reliance upon investment management since the value of your Drawdown funds will reflect the value of the underlying assets.
• 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 perfomance at least once a year and make changes to asset allocation in accordance with your attitude to investment risk.

An Income Drawdown Plan gives you the following options:

• It allows you to select the level and timing of your income from your pension fund within the prescribed limits.
• You can take the maximum tax-free cash immediately and draw an income from your pension fund until you decide to buy an annuity to secure your pension for life.
• It gives you the option to postpone any decision about committing your entire pension fund to a particular type of pension, at a time when rates may not be favourable to you.
• You can keep your pension fund to remain invested in a tax efficient environment, for maximum potential growth, while taking an income from your fund.
• It lets you maximise the investment control you have over your pension fund, during your retirement.
• It gives you a more flexible income than you would receive from purchasing an annuity.
• You can avoid purchasing an annuity when annuity rates are near a historical low. Irrespective of the change of annuity rates, the fact you would be buying an annuity at an older age could offer you value for money.
• Protection of your estate - you can help preserve your estate, and ensures that your family receive adequate life cover from your pension savings.

Death Benefits

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

1. Receive a cash lump sum, after an income tax deduction of 35%.
2. Purchase a conventional annuity, based on their own age and gender.
3. Continue with drawing an income from the fund. Income levels will be reset based on the survivors age and the GAD rates applying at that time and cannot exceed the level of income the policy holder could have received had he/she purchased an annuity immediately prior to his/her death.
4. If the drawdown option is chosen, the survivor may change their mind and take the cash lump sum subject again to the 35% tax charge.
5. If the surviving spouse is aged under 60, he or she may defer taking any benefits until age 60, when a conventional annuity must be purchased.

The Choice of Drawdown provider

The choice of drawdown provider is determined by the reason for entering into the drawdown contract. The providers can broadly be categorised into three groups: -

1. Life insurance companies
2. Restricted Self-Invested Personal Pensions (SIPPs)
3. Unrestricted SIPPs

A life insurance company drawdown plan may be suitable for a client who is seeking simplicity and relatively low cost access to drawdown using primarily pooled funds e.g. pensions with-profit or pensions managed fund.

A restricted SIPP offers the ability to invest in pooled funds, e.g. unit and investment trusts and a restricted number of direct equity investments, and would be suitable for a client who is seeking to invest in a wide range of funds, with minimum administration costs.

An unrestricted SIPP would allow investment into a wide range of qualifying assets, including land, pooled funds, any UK Stock Market listed equities and International equities, probably with the appointment of a stockbroker as an active manager of the equity element of the investment fund.

Choice of investment link

One of the attractions of drawdown is the ability to remain invested in equity based investments even thought an income is being drawn from the fund. The choice of investment link will be based on a number of factors, which include: -

• Your attitude to risk.
• The purpose of the plan.
• The relative importance of the plan, given other financial circumstances.

The risk factors

Pension fund withdrawal whilst offering considerable flexibility presents a number of risks, which are detailed below: -

1. 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 could result in a lower income when the annuity is eventually purchased than was available when drawdown commenced.
2. The investment returns may be less than those anticipated.
3. Annuity rates may be at a worst level when purchase of annuity takes place; again resulting in a lower income than was available when drawdown commenced.
4. 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.
5. The charges from a drawdown plan will be higher than those under a conventional annuity due to the complexity of the contract; the ongoing need for advice and active investment. These will ultimately reduce the value of the fund available to provide income.

The need for ongoing advice

With a conventional annuity the decisions with regard to guarantee period, spouse protection, escalation etc. are all made at the outset and the only potential area for review is investment linking, if a unit-linked annuity is chosen.

With the drawdown and phased retirement options, a considerable amount of ongoing advice is required to determine when and how benefits should be drawn.

A client’s health, marital status, attitude to risk and need for income may all change during the drawdown period, which may require adjustment of the investment link or income level withdrawn.

All of the above mean that there is a need for ongoing advice until an annuity is eventually purchased.

Reasons why drawdown may be appropriate

The major attraction of drawdown over a conventional annuity is the ability to retain an element of control over your pension funds, whilst having immediate access to the tax-free lump sum and drawing an income. There are a number of circumstances where drawdown maybe particularly appropriate.

1. Where there is a need for income flexibility in retirement e.g. due to ongoing but variable income from work.
2. Where income is required, but you wish to defer committing to a guaranteed annuity e.g. due to uncertainty over health.
3. Where you wish to retain the flexibility to take advantage of fluctuating annuity rates.
4. Where you wish to retain control of the investment of your accumulated fund whilst drawing an income.
5. Where provision of flexible benefits is required (particularly the lump sum payment) in the event of death before annuity purchase.
6. Where tax free cash is required, without commitment to a purchase of an annuity.

Risk warnings

• Recommendations are based on our understanding of current tax legislation, which may be subject to change and review.
• Future annuity rates are not guaranteed; they can and will fluctuate on a daily basis, down as well as up. This is because they are dependent upon economic conditions and are frequently changed.
• High-income withdrawals may not be sustainable, especially if investment returns are poor and a high level of income is being taken. This could result in a lower income when the annuity is eventually purchased. This is especially so where investment returns are poor. This can result in a lower income once an annuity is eventually purchased.
• The investment returns may be less than those shown in the illustrations.
• If there is prima facie evidence that a client in ill health elects not to take benefits at the specified age in order to increase the estate of someone else, the Capital Taxes Office may consider the failure to take retirement benefits gives rise to a charge to IHT. For death within Drawdown, rather than ASP, this is unlikely to be pursued where the investor survived for two years or the death benefit was paid to a spouse and/or dependent.
• Due to fluctuating value of the funds actually paid to purchase your pension, your future annuity could be greater or smaller than the values used in this report. There is no guarantee that annuity rates will improve during the drawdown period of deferral: indeed, they may deteriorate.
• The funds that remain invested in the pension plan could leave you open to investment risk during the drawdown period.
• Past performance of investment funds is not necessarily a guide to future returns.
• There are no guarantees that your income will be greater than if you used your entire fund to purchase a pension immediately. If annuity rates fall, or investment growth is poor, your retirement income could be lower.
• With annuities, those who die prematurely effectively subsidise those who live longer. Where you defer buying an annuity – as you will both be doing by effecting drawdown arrangements – the benefit of this cross-subsidy is reduced. This is known as "mortality drag" and increases the yield your drawdown funds must achieve in order to match what the value of the retirement benefits you could get through buying annuities.