Paul Leatherbarrow, Liverpool
Planning your retirement if you are planning to retire in the next few years, you are no doubt thinking about how to take an income from your hard-earned pension fund. There are a number of options available. Thanks to pension rules introduced in April 2006, pension investors have increased flexibility at retirement. State pensions at state pension age (65 for all men, and women born after 1955) you will normally receive a basic state pension.
The amount you receive will depend on your national insurance record. The full state pension for tax year 2009/10 is £95.25 per week for a single person, and £152.30 for a married couple. If you have been employed and contracted into the State Earnings Related Pension scheme (SERPS) or State Second Pension (S2P), you will receive an additional second state pension.
People over 60 with a modest retirement income may also be entitled to an additional Pension Credit. What exactly are your options? When you retire your pension fund does not always automatically start paying you an income. Instead, after taking any tax-free cash, your pension is normally converted into a separate contract which then provides a taxable income - even if that happens to be with the same company with which you have built up your pension.
Your income could be provided using an annuity or an income drawdown arrangement. The earliest you can take retirement benefits is from age 55. Tax-free cash On retirement you will normally be given the option of taking a tax-free lump sum . The tax-free cash is, as the name suggests, totally tax-free. You can usually take up to 25% of your pension fund. Tax-free cash is also known as “Pension Commencement Lump Sum”. 25% tax-free cash is now available from most pensions including those where it was previously not allowed, such as from protected rights and AVCs, providing your pension scheme allows this.
Tax-free cash from occupational schemes is taken from the scheme as a whole, so you may be able to take more or less than 25% tax-free cash from an AVC. Before making any decisions you should contact your scheme administrator. If you wish to reinvest your tax-free cash into a pension, you should check that the rules allow you to do so without adverse tax consequences.
There are restrictions on tax-free cash “recycling” and this is normally not possible without severe tax penalties. Conventional Lifetime Annuity An annuity is the simplest retirement option and is a secure, taxable income which is payable for the rest of your lifetime. Once set up, an annuity cannot normally be changed, so you can rest safe in the knowledge that your annuity income will never run out. Different insurance companies offer different annuity rates and these can change frequently. This means some companies are more competitive than others.
What is the “Open Market Option”? And what difference could it make? Your current pension provider may not offer the best retirement income. If you do take the income they offer without first checking how competitive it is, you risk being locked into a poor deal for the rest of your life.
The “Open Market Option” is your legal right to shop around and buy your annuity with a more competitive provider. Using the Open Market Option produces a better income in the vast majority of cases, and at no extra cost. It could boost your income by thousands of pounds. The top company can change frequently and will vary depending on your circumstances and the kind of annuity you choose. What are your annuity options? There are a number of options you can choose when setting up your annuity. These are decided at outset and, once set up, cannot normally be changed.
Choose an income that benefits your spouse or partner (joint life) If you are married or have a partner, one of the decisions you need to make is whether you want your spouse or partner to receive an income if you die before them. This is known as a joint life annuity. After your death, your surviving spouse or partner will continue to receive an income for the rest of their life. or alternatively choose a reduced amount such as half or two thirds.
A joint life annuity may be less important to you if your spouse has an adequate retirement income of their own. Choose an income that pays out for your lifetime only (single life) here the income is paid for your lifetime only and does not continue to anyone else on your death. The income you receive each year will be higher than a joint life annuity.
Choose an income that remains at a constant amount each year if you select an income that remains level, you will generally receive a much higher initial income than an annuity that does increase. However, as time goes by, the real value of your income will be eroded by the effects of inflation, so you will be able to buy less with your income. Choose an income that keeps track with inflation, or increases by a set amount each year You can choose an income that moves in line with the Retail Prices Index (RPI), thus keeping track with inflation - whether up or down. This means your income will retain its buying power. You can also choose an income that increases by a fixed amount, such as 3% or 5% a year.
Over time you might receive a higher total income, but your starting income will be lower. Choose an income that is guaranteed to be paid for a minimum of 5 or 10 years, even if you die before then All lifetime annuities will pay out for at least the whole of your life. However, you can also choose for the income to be guaranteed for a minimum period of time from when it was set up (usually 5 or 10 years). If you die before the end of the guarantee period, the remaining income payments left under the guarantee will normally be paid as continuing installments to your estate or to the person or people you have nominated in your Will, if you have made one.
Protected rights Your fund will contain protected rights if you have used your pension to contract out of SERPS (State Earnings Related Pension Scheme) or the State Second Pension (S2P). The income from this part of your pension pot must include a 50% spouse’s pension if you are married or in a civil partnership, and will be paid to the person who is your spouse or civil partner at the date of death. The rates are unisex and the maximum guarantee period is 5 years. You can take up to 25% tax-free cash and take benefits from age 55 (50 until April 2010). The rules of some pension schemes may have additional restrictions.
Enhanced annuity rates If you have certain health conditions, you may be able to obtain a higher income. This is because statistics show that smokers and people suffering from certain medical conditions have a shorter than average life expectancy. If you suffer from very serious ill health, you should seek advice. If your life expectancy is very short (under 12 months) you may be able to take the whole fund as a lump sum. Choose an annuity with Value Protection You can choose an annuity that protects the value of all or some of the amount you paid for your annuity if you die before age 75. If you die before the total gross income paid out exceeds the amount of the fund used to buy the annuity, the balance is paid, less a 35% tax charge.
Value Protected Annuities tend to be more expensive than conventional Investment Linked Annuities Investment Linked Annuities are designed to give you the opportunity to obtain an income that increases during your retirement. Unlike conventional annuities, these are linked to an underlying investment fund so they contain an element of investment risk.
Your future income should increase as the fund grows – but conversely, if the fund value falls, your income should decrease. As your annuity investment is directly exposed to stock market forces, income will fluctuate in times of volatility. Investment Linked Annuities do not give the high security offered by conventional annuity plans. Some annuity providers offer With-Profits Annuities.
These are investment linked annuities based on the With-Profits fund of the annuity company concerned. Income Drawdown (Unsecured Pension) This is a very flexible option which may be a consideration for more substantial funds, or if you have other sources of income. Income drawdown allows you to take a taxable income each year directly from your fund, leaving the remainder invested. The real advantage is its flexibility and potential for growth. You can choose the level of income you receive, yet continue to manage and control the remaining fund.
Should you die before the age of 75 and before you have converted to an annuity, one option is for the remainder of the fund to be paid as a lump sum to your beneficiaries, subject to a 35% tax charge. The death benefits can thus be more attractive than those available under a lifetime annuity - There are limits on the amount of income you can take each year, reviewed every five years. There is no minimum income, which means in theory you can take tax-free cash and leave the remainder fully invested. The maximum income you can take may be more than the income you can receive from a single life level annuity.
This offers maximum flexibility and performance potential. The charges for setting up and administering income drawdown can be higher than for a lifetime annuity. It also requires on-going attention and reviews. Income drawdown is considered to be high risk when compared to an annuity as the income can fall as well as rise. An annuity can be bought with your drawdown fund at any time. Variable Annuities Recently some providers have launched products which offer something in between income drawdown and annuities.
They tend to offer an income or capital guarantee combined with potential investment growth. Phased Retirement Rather than convert the entire pension fund into an annuity or drawdown all in one go, Phased retirement allows you to set up a series of annuities or drawdown arrangements by gradually drawing on your fund over a period of time. Each time you take benefits in this way you can take up to 25% tax-free cash, plus a taxable income.
The remainder of the fund continues to be invested. Phased retirement can be particularly useful if you do not need all the income or tax free cash at the start, or if you are worried about death benefits. It allows you to set up a variety of income types, so for instance you could choose an annuity with a dependant’s pension, and another with yearly increases, or combined with drawdown. It can be tax efficient as income can be supplemented by tax-free cash payments. Phased retirement provides an increase in flexibility.
You can encash different parts of your pension fund at different times to provide income when required, however this does not solve the problem of possible poor annuity rates in future. The growth on the invested fund may not compensate for the income you could have received had you taken an annuity with the entire fund on day one. Mortality Drag Put simply, annuities work on a principle of cross-subsidy: the people who die earlier than expected subsidise those who live longer. In any one group of annuitants, some of the people will die in the early years. If you delay purchasing an annuity in favour of income drawdown, when you eventually buy your annuity you have lost out on the cross subsidy of those who have already died. This means the fund has to work harder to catch up.
This is “mortality drag”. Alternatively Secured Pension from age 75 it is no longer a requirement for a pension fund to be converted to an annuity by age 75. Alternatively Secured Pension (ASP) works rather like income drawdown, but only for people aged 75 and over. ASP plans will not pay out any tax-free cash. If you want to take tax-free cash, this must be taken when starting income drawdown before you reach age 75.
The maximum income from ASP will be approximately 25% less than the same fund would have provided in income drawdown, so where you are looking to maximise your income this may not be attractive. The maximum limit will be reviewed every year, but always assuming you are age 75.
The minimum income you must take is just under 50% of the income the same fund would have provided in income drawdown. Like income drawdown, the fund remains invested: you take a taxable income directly from the fund. The rest is invested and you retain full control over the investment decisions. The value of the fund can fluctuate and income can fall or rise on an annual basis. On death, the remaining fund must be used to provide an income for dependants.
If you have no spouse or dependants, your fund will be paid to a charity of your choice (free of inheritance tax). Note ASP is not a way of avoiding inheritance tax and you should consider the potential tax charges when making your decision.
What happens when you die after retirement? Lifetime Annuity (no value protection) Nothing payable unless:
1. You have selected an annuity that includes an income for your spouse or dependant. In this case, payments will continue to be made until their death.
2. You die within a predetermined guarantee period. The balance of the outstanding payments will normally continue to your estate or the person or people nominated in your Will, if you have made one. Benefits normally have to be chosen at outset.
Lifetime Annuity with Value Protection This will pay out any unused capital if you die before age 75. The amount paid will represent the difference between the fund used to buy the annuity and the gross payments made so far, and will be taxed at 35%. After 75, the position is the same as a conventional annuity. Phased Retirement (phased annuity purchase) Where funds have been “vested” (been used to generate income and tax-free cash) the death benefits are as for an annuity or income drawdown (unsecured pension). Any part of the fund that has not been vested will normally be returned to your beneficiaries free of inheritance tax.
Income Drawdown (Unsecured Pension) There are several options for the remaining fund:
1. Return of fund. The funds which are in income drawdown can be paid to the beneficiaries less a 35% tax charge taken from the fund.
2. Spouse or dependants can use the fund to purchase an annuity. There is no tax charge on the fund but their continuing annuity is taxed at source under PAYE.
3. Spouse or dependants can continue to draw an income from the fund through income drawdown, or alternatively secured pension (from age 75).
The income is taxed at source under PAYE. Income Drawdown and Alternatively Secured Pension (ASP)
• Once set up income is fixed and secure The income will never run out, however long you live Available for pension funds of all sizes
• No ongoing reviews required
• No investment risk:
• not affected by stockmarket falls, or economic slumps
• Can be inflexible Cannot be changed An annuity (without value protection)
• cannot generally be passed on to your beneficiaries as a lump sum
• Current annuity rates are perceived to be low
• Spouse’s benefits must be set up at outset - so can be wasted on divorce or if spouse dies first
• Not affected by stock market rises
• You do not have to make a one-off choice
• You retain investment choice and control
• Can potentially pass pension fund on to beneficiaries before age 75 (less 35% tax)
• More flexible
• You can plan the income you receive to match your requirements
• Potential for growth
• More complex, you may need advice
• Requires regular review
• Some plans can be expensive: may not be cost effective for smaller funds
• An annuity set up on day 1 may have offered a greater total income over lifetime
• High income withdrawals can strip the fund bare
• The income and value of the fund can fall.
• Where to invest your pension fund before retirement
Even if you are not planning to retire for several years, you should consider the structure of your pension fund. Act now, and you could make all the difference to your retirement income. If you are thinking of buying an annuity soon, you may wish to consider switching to lower risk investments, such as gilts and bonds (known as fixed interest) and cash.
This may protect your pension fund from market volatility prior to retirement and can help preserve its annuity purchasing power. If you are planning to keep your pension fund invested during some or all of your retirement, for instance by using income drawdown, there is less of a requirement to protect your fund before retirement.
The lifetime allowance the value of your total pension savings will be subject to a lifetime allowance which for tax year 2010/11 is £1.8 million (to be frozen at this figure for five years). Any funds over the value of the lifetime allowance could be subject to a tax charge of up to 55% at retirement. To assess whether your funds are above the lifetime allowance you need to value all your pensions. You should add all your pension funds together, multiplying final salary pensions not yet in payment by 20 (plus any additional tax-free cash) and any pensions in payment before 6th April 2006 by 25. State benefits may be excluded from the calculation. Special rules apply to individuals already in income drawdown.
When you take benefits, (ie via an annuity or income drawdown), the rules require a check to be made to ensure the lifetime allowance is not being breached. Your pension or annuity provider may need to obtain details of all your pensions for confirmation on how much of the lifetime allowance you have already used up.
We believe it is very important that you seek independent financial advice as soon as possible if your pension fund is likely to exceed the lifetime limit now or at some point in future. Triviality rules If your pension savings are less than 1% of the lifetime allowance (£17,500 for tax year 2009/2010) in total, including occupational pensions, AVCs and pensions in payment, you may be able to take them as a lump sum. You must be between 60 and 75, and 75% of this would be subject to income tax.
This can only be done once There are separate rules for small occupational schemes. Advice on Your Retirement Options We recognise that retirement is an important financial decision. We have a number of professional advisers who are able to offer independent, impartial advice. Whatever your current pension arrangements, they can help you decide which arrangement is suitable for your particular circumstances. They are able to provide specialist advice on all aspects of financial planning, and can advise you if your pension plans are already at the lifetime allowance, or are likely to exceed the lifetime allowance in future.
Should you have any doubt as to the suitability of an investment for your circumstances you should seek expert independent advice.
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