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Pension Drawdown

Income Drawdown is a means of taking tax-free cash and/or an income from your pension pot without locking into a lifetime annuity. The pension remains invested in the markets, unlike an annuity, so you continue to carry the investment risk. However, you do retain considerable flexibility both in terms of the income you can draw and also the death benefits. You can decide to buy an annuity with the fund, or a part of it, at any time - for example, if annuity rates increased.

What types are there?

There are a number of options when it comes to pension drawdown;

Conventional Income Drawdown

Typically you would opt to take the 25% Tax-Free Cash at outset and then draw a regular monthly income from your fund if/when required. The balance of investments within the plan would be managed by your adviser on a day by day basis, so as to generate a sustainable income while also aiming to grow the value of the plan. The income taken can be varied according to your circumstances - for example, the income could be managed so that you remain a basic rate taxpayer, to supplement an irregular self-employed income or to top up your other pension income.

The maximum annual allowance for pension contributions is now £40,000, and the lifetime allowance is now £1.25m. The changes came into effect on 6th April 2014. The annual allowance was last reduced in April 2011, when it fell from £255,000 to £50,000.

The cut in the maximum annual pension contribution will hit many middle-income workers in final salary pension schemes, particularly those in the public sector, such as teachers, doctors and MPs.

Higher earners in the private sector can control how they save for their retirements and factor in the revised allowance.

Workers can still use the "carry forward" tax loophole, which allows contributions to be spread over up to three years. Each could, potentially, invest up to £190,000 - assuming a £50,000 allowance from the previous three. Savers must have sufficient income to obtain tax relief on this amount - contributions cannot exceed earnings.

Wealthier savers

Nil Drawdown

You may wish to take the 25% Tax-Free cash but no income. This may be because you want to pay down a mortgage or other debt, but are still working and have no need for the income. In this scenario, your plan could be managed to generate capital growth until such time as you choose to start drawing an income from it.

Phased Drawdown

This is a variation of Income Drawdown. Rather than take the 25% Tax-Free Cash at outset, you would instead opt to take the cash in phases with each income drawn. This means that a proportion of each income payment is tax-free. This can generate a very tax-efficient income.

Income Recycling

There are very strict rules on the "recycling" of tax-free cash into a pension plan, as you would receive tax relief on the contribution. However, there are no such restrictions on the recycling of annuity or drawdown income back into a pension plan. The benefit is that you accumulate another pension pot from which you can subsequently draw 25% as Tax-Free Cash. The recycling itself is tax-neutral as you will pay tax on the income at the same rate as you will attract tax relief on the contribution.

More information

Income Drawdown - The Risks

Income Drawdown offers a very flexible alternative to annuities. However, it carries a number of inherent risks and is generally only suitable for people with additional sources of income, and who are willing and able to take investment risk.

What are the Risks?

Investment Risk

You continue to carry the investment risk on the plan. If the investment performance is poor then the plan will drop in value and you may end up worse off than if you had bought an annuity. This is why it is critical that your adviser actively manages the plan with you and that it is reviewed regularly.

Annuity Rate Risk

Annuity Rates may fall during the time you are in the Drawdown Plan so that when you do buy an annuity you could be worse off.

Fund Erosion

Drawing an unsustainable income from an Income Drawdown Plan will rapidly erode its value. This is why it is critical to regularly review not only the investments with your adviser, but also the level of income you draw.

Mortality Drag

When buying an annuity those annuitants who live longest are effectively subsidised by those dying earlier. However, this cross-subsidy does not benefit Income Drawdown clients and so the rate of return has to effectively increase each year of the plan to match the benefits of an annuity.

Legislation

Widespread consultation across the pensions industry is likely to result in changes to legislation over the coming years. It is expected that the rules concerning income levels and death benefits will be closely scrutinised.

Insolvency

Income Drawdown Plans are covered by the Financial Services Compensation Scheme (FSCS), but the level of cover will depend on the types of investment and how they are held.

Income Drawdown on Death

One of the major drawbacks with annuities is that the Annuity Provider keeps your capital on your death. The rules applying to Income Drawdown are very different and potentially allow your spouse/beneficiaries to access the capital on your death.

If you die before Age 75, and are in an Income Drawdown Plan, then the following options currently apply:

    • Your spouse/beneficiaries can take the fund as a lump sum, subject to tax at 55% .
    • Your spouse can buy an annuity with the residual fund.
    • Your spouse can continue to draw an income from the fund.

It is widely expected that Income Drawdown rules will continue to be amended to allow more flexibility when drawing an income.

For more information about Pension Drawdown please contact the Pension Adviser

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