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12th December 2010

Draw down forever!

Updated: 12th December 2010

The government will change the post-retirement rules for pensions from April 2011.  Whilst a fortunate few will benefit, most people will notice no change and most of the “squeezed middle” already in drawdown will face more restrictions.

Who should read this?

This briefing note will be of interest to people who are close to or already drawing down from their pension. It should be useful to younger people wondering whether it is worth using a pension as a vehicle for saving for their financial independence.

This briefing note is about rules for individual pensions such as personal pensions or SIPP; not final salary pension scheme benefits.

The headlines

There are two useful changes which are due to come into force from April 2011.

First, there is no need to make any change to a pension fund at age 75. You will not be forced to buy an annuity.

Second, if you can prove you have a minimum of £20,000 a year individual pension income you will be able to draw down unrestricted amounts from your pension funds.

What happens currently?

Currently from age 55 to 75 you can take a tax-free cash lump sum (usually 25%) from your pension fund and either buy an annuity or draw down an “unsecured pension” from the fund.

At age 75 if you don’t want an annuity you can take Alternatively Secured Pension. This option has strict income limits and an eye-watering 82% tax on any cash lump sum paid on death. It is not a practical option for most people and effectively forces people to buy an annuity.

What’s wrong with an annuity?

Not a lot.  Annuities are a cost-effective way of buying guaranteed life-time income.  They will remain the most suitable source of retirement income for most people.

An annuity is insurance against living too long. You hand over a premium (your pension fund) and the insurance company guarantees to pay you an income for the rest of your life – however long or short that is.

Objections to annuity purchase are often emotional, although this makes them no less valid.  For example, most PageRussell clients will be on the “winning” side of the annuity gamble and live longer than average; but we understand why they may not want to take the risk.  So we understand why having an alternative to an annuity is important.

Drawdown forever

From April 2011, the same options will be available at whatever age you take your pension benefits after your 55th brithday:

Buying an annuity will continue be appropriate for many retirees, especially as money-back guarantees will be allowed on death after age 75.

Capped drawdown
This option will be a more restricted version of Unsecured Pension.  The maximum income limit will be reduced from 120% to 100% of an equivalent annuity (known as the GAD rate). The minimum limit will stay as £Nil.

Flexible drawdown
This option will allow individuals to draw down unrestricted amounts from their pension pot, provided that they can demonstrate that they have secured a sufficient minimum income to prevent them from exhausting their savings prematurely and falling back on the state.

The 25% tax-free cash option will remain available, even after age 75.  All benefits drawn down will continue to be taxed as income.

Minimum Income Requirement

Flexible drawdown is a useful innovation. But before we get too excited, individuals will have to satisfy Minimum Income Require (MIR) initially set at £20,000 a year.

The MIR is designed to stop people spending their pension fund and then falling back on means-tested benefits in retirement.

The following types of pension income can count towards the MIR, as long as they are already in payment:

  • Basic and additonal state pension
  • Pension annuities, including dependents pensions
  • Occupational scheme pensions
  • Certain overseas pensions

The pension will not have to be index-linked (which can add 30% to the cost of providing a pension).

The following types of income will NOT count against the MIR:

  • Salary or other employment income
  • Share dividends or gilt interest
  • Purchase life annuities
  • Drawdown pension income, or dependents drawdown income
  • Means-tested state benefits, such as pension credit.

An example provided by HM Treasury is of a 65 year old man with £5,078 basic state pension and £2,500 additional state pension, but no other pension income.  A healthy 65 year old would need a pension fund of roughly £233,000 to buy the £12,500 a year annuity income to meet the MIR.  Any extra pension fund can be put into flexible drawdown and taken as taxed income without restriction.  Alternatively this person can stick to the more restrictive capped drawdown.

What happens if you die?

This is the main sting in the tail of these changes.  On death any funds in drawdown (capped or flexible) which are paid out as a lump sum will be taxed at 55%. This compares with 35% now for Unsecured Pension and 82% for Alternatively Secured Pension. This is good news for those aged over 75, but bad news for younger people.  Financial dependents can avoid this tax by buying a dependent’s annuity or continuing in drawdown, but other beneficiaries will have to accept the tax charge.

Untouched pension funds can be paid out as cash, free of inheritance tax before 75.  After age 75 untouched pension funds will suffer the 55% tax charge.  However, in a welcome clarification, the HM Treasury have confirmed no further inheritance tax will be charged.

Welcome reforms

PageRussell believe these planned changes are welcome if they give savers more confidence that money saved in a pension is not wasted.  However, drawdown will remain a minority sport. 

We expect the Financial Services Authority to issue more restrictive rules on drawdown advice in response to these reforms.   This will further restrict access to full flexibility in retirement to the wealthy.

If you have any queries please email Tim Page at ku.oc.llessuregapnull@mit

More information is available from HM Treasury .

Important declaration

This document does not recommend you buy, redeem or vary any regulated investment. It is believed to be accurate as at 12th December 2010; however no warranty is given as to its accuracy and no responsibility can be accepted by Page Russell Ltd for any action taken in reliance on its contents.

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