Pension Drawdown
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pension drawdown, pension draw down, income, pension release, DRAWDOWN
Rather than using a pension fund to buy a pension annuity at retirement, some
people may prefer to drawdown on their pension fund now and wait until they
are older when annuity rates could be higher. An alternative route could be
to use phased retirement where only part of their fund is used for a compulsory
purchase annuity, however, by age 75 an annuity must be purchased. Both pension
drawdown and phased retirement will require a fairly large initial fund value
in order to make it worthwhile, usually about £100,000. It is also more suitable
to individuals that continue to have other income sources to rely on such as
working part-time or income from other pensions, such as a final salary pension.
As the pension fund remains invested typically in equity based investments,
the individual must be prepared for some volatility in the fund in the future.
However, It is possible that by delaying a pension annuity the individual, or
their partner, will suffer from ill health and when the pension annuity is purchased,
benefit from improved rates from impaired life annuities. There is also the
potential for future growth in the fund and the tendency for annuity rates,
and hence pension income, to increase with age. With even larger funds of £250,000
or more, an open annuity could offer similar flexible benefits as pension drawdown
but also the possibility on the death of the member, of leaving the residual
pension fund to nominated beneficiaries. Pension Drawdown.
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Originally this was known as pension drawdown but in 1997 the Personal Investment
Authority (PIA) changed its name to pension fund withdrawal. The concept was
introduced by the Inland Revenue as an alternative a pension annuity. Pension
fund withdrawal was originally introduced as part of the Pensions Act 1995 and
integrated into the existing personal pension structure rather than create a
new product. Although it is possible for an individual to use pension fund withdrawal
from an occupational pension scheme, called occupational drawdown, this is usually
only considered if the tax free lump sum from the occupational scheme is greater
than the 25% tax free cash from a personal pension. If it is less, an individual
that wants to benefit from pension fund withdrawal will usually transfer to
a pension. On transferring to pension fund withdrawal, the individual can take
all the tax free lump sum initially and then take an income between limits prescribed
by the Inland Revenue. These withdrawal levels are subject to minima (being
35.0% of the maxima) and maxima based on the Government Actuary's Department
(GAD) tables on long-dated gilt yields that are reviewed every three years.
Every three years the pension fund is subject to a triennial review. At this
point new GAD tables are applied to the individual and this could mean that
the maximum income that can be withdrawn will change. This is because the individual
is older and receive a higher income or if the gilt yields have fallen, a lower
income. On the death of the individual in income drawdown, their spouse will
have a number of options. They could continue with the income drawdown until
they are age 75 or until the time their deceased spouse would have reached age
75, whichever is the sooner. The spouse could purchase a pension annuity or
take the whole fund as a tax free lump sum and pay a 35% tax charge.
Advantages The following are a number of advantages of pension drawdown that
reflect the benefits of deferring taking a pension annuity until later:
An individual will be able to take a tax free cash lump sum immediately to
spend or invest as they wish. This option is not available through the phased
retirement option but is available through the annuity and open market option.
The level of income which may be withdrawn, is determined by the GAD. Income
may be withdrawn up to the determined level but a minimum of 35% of this income
has to be withdrawn within any 12 month period.
Subject to the above limits, the individual will be able to plan in advance
the level of income that they wish to take each year, so that they can take
into account any other sources of income which may be available to them.
The pension fund value (less any income withdrawn and associated charges)
will continue to be invested until the individual decides to purchase an annuity.
Depending upon investment returns, which can fall as well as rise and are
not guaranteed, this may provide the opportunity to achieve sufficient growth
to improve the ultimate benefits when the individual decides the time is right
to purchase an annuity. However, an annuity must be purchased no later than
age 75.
The individual can structure their income to mitigate the liability to personal
Income Tax. By reducing their income in some years, they may be able to avoid
higher rate tax liability.
Potential death benefits may be greater than under the conventional annuity
route, although a 35% tax charge will apply to any lump sum death benefits payable
under any policy from which they have started to draw income.
The remaining pension fund (i.e. policies not being used to provide income)
can be returned to the individual's beneficiaries, in pension form, free from
Inheritance Tax and the additional 35% tax charge.
The individual may be able to use a Pension Fund Withdrawal as part of their
Inheritance Tax planning by using varying levels of income, within prescribed
limits, and using all or part of the income to make gifts to take advantage
of annual exemptions.
They can delay purchasing their annuity if the individual thinks the rates
will improve, although an annuity has to be purchased by age 75.
Disadvantages The following are a number of advantages of pension drawdown
that reflect the disadvantages of deferring taking a pension annuity until
later:
There is no guarantee that the individuals income will be as high as that
offered under the pension annuity (or compulsory purchase annuity).
The value of the pension fund may not achieve the required level of growth
to maintain income levels at the same level to those achieved through the purchase
of a pension annuity purchased at outset.
This is because income payments are technically withdrawals of pension fund
capital and these payments may erode the value of the pension fund, if investment
returns are not sufficient to make up the balance and this includes charges
for the ongoing plan administration.
There is no guarantee that annuity rates will improve in the future. They
could be lower when the individual decides to purchase their annuity than the
current rates. The pension may be lower than if the individual bought a pension
annuity.
The value of the pension fund may go down as well as up. Additionally, the
individual may not have a sufficient fund available to purchase an annuity equivalent
to the amount out would have received at outset.
Death benefits payable as a lump sum (under contracts being used to provide
an income) are subject to tax at a special rate of 35%. In addition if the lump
sum is not paid to the individual's spouse there might be additional further
liability to Inheritance Tax.
If they have not purchased an annuity by age 75, at that point the individual
will have to purchase an annuity on the rates current at that time.
The individual may feel that the prospect of future higher income does not
compensate them for being able to enjoy a guaranteed and secure level of income
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