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Pension Drawdown

Gone are the days when the investments in your pension plan must be used to buy an annuity. ‘Income Drawdown’ allows the individual to simply spend the money in the accumulated pension scheme by drawing an income from the accumulated funds, while the balance remains invested and can continue to benefit from any continued growth.

Generally speaking, this method of decumulation may only be suitable for people with over £100,000 although this will depend on the pension plan, the charging structure and the exact circumstances of the individual.

The rules of taking pension benefits have changed dramatically since Pensions Freedoms came into force in April 2015.  This legislation allows individuals to fully access their defined contribution pension assets so depending on their pension scheme, people may be able to take all or some of their pension benefits as a lump sum.  However it should be noted that more income tax may be payable if large withdrawals are made in the short term as opposed to over a longer period of time.

 The exact rules governing Income Drawdown are subject to constant review and adjustment by HMRC, but there are currently two versions which are available: ‘Uncrystallised Fund Pension Lump Sum (UFPLS)’ and ‘Flexi Access Drawdown (FAD)’.  Both of these Income Drawdown methods may trigger the Money Purchase Annual Allowance (MPAA).

Uncrystallised Fund Pension Lump Sum

  • Normally, 25% of the UFPLS is paid tax free as Pension Commencement Lump Sum (PCLS) with the remaining balance taxable as pension income at the individual’s highest marginal rate
  • Care is needed as at least 75% of all withdrawals are treated as earned income in the tax year taken and taxed accordingly
  • Annual allowance is reduced to £10,000 per annum, so only really suitable for people who have almost finished accumulating capital for use in retirement

Flexi Access Drawdown

  • The individual can draw unlimited amounts back out of the pension plan
  • Pension Commencement Lump Sum (PCLS) can be withdrawn without taking any taxable income from the pension
  • Care is needed as all withdrawals are treated as earned income in the tax year taken and taxed accordingly
  • Annual allowance is reduced to £10,000 per annum, so only really suitable for people who have almost finished accumulating capital for use in retirement

Risk

Drawdown carries two main types of risk that need to be managed: investment risk and mortality risk.

Investment Risk: as the balance of the funds remain invested, the responsibility rests on the individual to manage the investments to protect the underlying capital. Due to poor returns or significant income taken from a pension plan, a pension may be fully withdrawn before death.

Mortality Risk: As harsh as it sounds, purchasers  of annuities benefit from the early deaths of other annuity holders. This cross subsidy does not exist with drawdown.

Principal advantages

  1. Tax Free Cash / PCLS can be taken independently of pension income. Those still earning but wanting access to a lump sum can use Flexi Access Drawdown in this way
  2. Flexibility – income can be turned on and off as required. This can be helpful for tax planning purposes for those with other assets or income
  3. People who suspect their health will deteriorate can draw income until an enhanced or impaired life annuity becomes available
  4. On death before age 75 in drawdown, the remaining fund can be used by a spouse in the same way for income drawdown or a tax free lump taken. On the second death, the remaining fund (less taxes if over 75) can be left to children as a lump sum
  5. Opportunity to grow retirement benefits even during drawdown should investments perform well.

Principal Disadvantages

  1. The individual could run out of money before death! If investment returns are not adequate or income taken too large, then the withdrawals would erode the plan value
  2. Investment into ‘safer’ asset classes such as gilts and cash are unlikely to generate the returns required
  3. Investment into assets that have the potential to generate the returns required to protect the underlying fund value carry additional risk, and are not suitable for the short term
  4. Contract charges can be high on selected drawdown pension contracts
  5. Annuity rates might seem low now, but there is no guarantee that they will not be higher in the future

Lifetime Allowance

The Lifetime Allowance (LA) is a limit on the amount of pension benefit that can be drawn from pension schemes without triggering an extra tax charge. The Lifetime Allowance has decreased steadily over the past 5 years.

The table below details how the Lifetime Allowance has changed over time: