Annuities and Income Drawdown

If you are nearing retirement, then it is vitally important to understand the range of options available to you, and how to take an income from your hard earned pension fund.

Since pension rules were changed in April 2006 you now have increased flexibility at retirement.

55 is the earliest age from which you can start taking pension benefits. The most popular option is to purchase a lifetime annuity with your pension fund which provides a secure income for life. However a big recent change is that you no longer have to purchase an annuity by the age of 75, though we still think that the purchase of an annuity remains the sensible option for many.

But it is possible to defer the annuity purchase until your 75th birthday, when annuity purchase is currently compulsory, by going into income drawdown (also called Unsecured Pension). This is the facility to take up to 25% of your fund as tax free cash, while keeping the remainder invested in the stock market until age 75.

During this period, you are allowed to take an income from your fund whilst it remains invested and has the potential to grow in value. There are certain Income Revenue limits designed to prevent you taking too high an income from your fund, which must be reviewed every three years.

Drawdown clearly carries several risks, such as your fund dropping in value and annuity rates falling, so it is normally only recommended to those with substantial pension funds, with other assets to live off or for those with spouses who are considerably younger than themselves.

As a rule of thumb, a fund in drawdown needs to grow by around 7 per cent a year after charges, in order to match an annuity. This is a high hurdle rate and can mean that your income may fall, or in a worst case scenario that you outlive your assets. 

To prevent this happening, the income you can take from Income Drawdown is limited to between zero and 120 per cent of what a standard annuity would pay for someone of your age and gender.
You are also required to have your Income Drawdown arrangements reviewed every three years to ensure that you are not withdrawing too much cash.

Death benefit rules For Income Drawdown

Many people like drawdown because of the death benefit rules, which allow your fund to pass to your dependents less 35% tax if you die before age 75 while doing draw down.
This can be particularly beneficial if you have a much younger spouse, you are in poor health or have a very large fund which you particularly wish to leave to your dependents.
If you have a younger spouse who is under 60 years old when you die, there is a special Inland Revenue dispensation whereby, providing your spouse leaves the drawdown plan intact after your death, he or she can purchase an annuity at age 60.
Alternatively, if your spouse is over 60 when you die, they can continue doing income drawdown until age 75, when an annuity must be bought. If your surviving spouse also dies while doing income drawdown, the remaining fund, less 35% tax, passes to his or her estate.

Trivial Pension

If your total pension funds are less than 1% of the life time allowance (currently £18,000 tax year 2010/11) then you are allowed to take your pension as a cash lump sum. 25% of which will be tax free and can be taken at any time between your 60th and 75th birthdays.

Tax Free Lump Sum Only

In certain instances you may wish to gain access to part of your pension funds as soon as possible, this is usually the tax free cash element of your pension which can be up to 25% of your retirement fund. This withdrawal is usually achieved using an Income Drawdown facility allowing you access to your tax free cash leaving the remainder of your funds invested to draw as an income at a later date. You can only take pension benefits once you have reached age 55. 

Open Market Option

The introduction of the Open Market Option has helped to revolutionise the Annuities market. You are now able to purchase your annuity from any provider in the market rather than being forced to purchase your annuity from the provider of your pension contract. This competition for your business has resulted in better rates for annuity buyers. It is therefore vitally important to shop around before committing yourself to an annuity purchase.

Conventional Annuities

Conventional annuities can provide a guaranteed income for life. The income is neither subject to investment risk nor mortality risk. This means that it doesn't matter what happens to stock markets, house prices or any other investments, and, the income will continue to be paid out, even if you live to a record breaking age. The level of income you will receive is determined at the outset and can be level, increasing on an annual basis at a pre-determined level or linked to an index such as the Retail Price Index (RPI).

Investment-Linked Annuities

Investment-linked annuities are similar to a conventional annuity in that they are simply a series of payments made at selected intervals in return for a pension fund. Unlike a conventional annuity, however, the pension funds that you use to buy this type of annuity are invested with the aim of being able to provide you with the potential for a higher level of income. Investment linking can be established using unit-linked funds or with profits funds for the underlying investment. The amount of income you receive can rise or fall depending upon the performance of the underlying funds.

Enhanced Rate Annuities

Smoking, medical condition or conditions, both past and present, can all influence your normal life expectancy. Some annuity providers now take this information into account when setting their annuity rates. This can mean substantially higher income levels than those payable from standard conventional annuities for smokers and those suffering from ill-health. 

Flexible Annuities

A small number of providers have developed what have been termed flexible annuities. This type of plan combines a guaranteed taxable income for a limited period with the balance of pension funds remaining invested. Typically this works by your pension funds being transferred to a personal pension plan and the tax-free cash entitlement being paid out to you immediately. Some of the pension fund is then used to buy a 5-year annuity, with the balance remaining invested in the new pension plan. This process can then be repeated every five years.