Learning Material Sample

Retirement planning Demo

8. Retirement options

In this chapter we discuss the benefit choices available to members of registered pension schemes when they start to draw retirement benefits.

Individuals have a number of choices when taking benefits from their pension plans. These may take the form of a tax-free lump sum (called the pension commencement lump sum under the post A-Day simplified regime) along with one or more methods of retirement income provision.

From 6 April 2011 the simplified regime has three methods of re...

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...ity purchase or drawdown pension withdrawals. The options available to an individual to some extent depend on the type of pension scheme they are a member of and the size of the fund held within the scheme.

What were the 2 unsecured retirement income options available before 6 April 2011?

 

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A pension can either be secured or unsecured. We will be looking at both of these in the next sections.

The main advantages of secured pensions are:

Security - the pensioner knows what income they will receive;

Simplicity – once the pension is i...

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...re no obvious signs of this changing.

There are 2 types of secured pension: a scheme pension and a lifetime annuity which we cover in the next sections.

What are the 2 main advantages of secured pensions?

 

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A scheme pension is a promised pension paid to a pension scheme member by the scheme administrator or an insurance company chosen by the scheme administrator. It can be secured by purchasing an annuity from an insurance company selected by the scheme administrator or can take the form of a pension paid directly from the scheme assets. Either way it is taxed as income.

All pensions paid from defined benefit arrangements are scheme pensions;

Money purchase arrangements can provide scheme pensions but the member must first be given the opportunity to select a lifetime annuity from their choice of insurance company. In practice because of the practical difficulties in guaranteeing a scheme pension from a money purchase scheme without purchasing an annuity it is unlikely that many money purchase schemes will offer this option, with large ...

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...illary death benefits such as dependants’ pensions, guarantee periods of up to ten years and/or pension protection;

Can be transferred to another registered pension scheme as long as the form of the pension does not change.

Scheme pensions can only be reduced if the reduction is the result of:

A pension share or other court order (e.g. on bankruptcy) reducing the scheme pension payable;

An ill-health pension stopping because the member has recovered;

A bridging pension ceasing or reducing at State pension age;

A global reduction to all pensions under the scheme (for example, on wind-up);

A requirement of public sector pension regulations e.g. where a pensioner is re-employed.

What 3 factors determine the level of pension available from a defined benefit scheme?

 

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A lifetime annuity is a pension paid from a registered pension scheme which has been secured by the purchase of an annuity from an insurance company. It is taxed as pension income.

Defined benefit arrangements cannot offer lifetime annuities. All money purchase schemes must offer members the option of a lifetime annuity from the insurance company of their choice. This is known as an open market option and means that the fund need not be used to purchase an annuity from the plan provider but can instead be used to purchase an annuity from another provider offering a better rate or a more suitable type of annuity.

The benefits received from a lifetime annuity depends on the size of the fund at retirement, the annuity rates available and the type of pension benefits selected. Until 6 April 2012, it also depended on whether the fund was comprised of protected or non-protected rights. However, from that date, protected rights ceased to exist as a separately designated type of pension an...

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.... This will be subject to a 55% tax charge.

Lifetime annuity rules

Lifetime annuities:

Must be paid at least annually for life

Must normally be guaranteed not to reduce (other than in the specified circumstances detailed below)

Can include ancillary death benefits such as dependants’ pensions, guarantee periods of up to ten years and/or annuity protection

Must not be capable of being assigned or surrendered except in the event of a pension sharing order

Can be transferred to another registered pension scheme as long as the form of the pension does not change.

Lifetime annuities can only be reduced if the reduction is the result of:

A change in RPI/CPI

A change in the market value of freely marketable assets

A change in an index reflecting the value of freely marketable assets

A change in the bonuses attached to a with profits annuity.

Under what circumstances can lifetime annuities be reduced?

 

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The two main factors affecting annuity rates are longevity and long term gilt yields.

Longevity

Longevity or life expectancy has improved substantially over the past century, mainly due to better social conditions and advances in medicine. This means that people are living longer and each generation spends more time in retirement. The issue that this creates for insurers is that the annuities they commit to pay will be payable for longer than was the case in the past. As a direct consequence of this annuity rates have fallen markedly in the last twenty years.

The following table shows the future life expectation at various ages, subject to the average mortality experience of England and Wales in the years 2005-2007.

Age

M ale Life expectation in yea...

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...etter rates. An individual’s postcode is also a factor, as certain parts of the country have a greater or lesser likelihood of early death based largely on affluence of the area. Although underwriting is also required for an enhanced annuity this is done on an automated basis using a points system, rather than being based on the individual’s medical record.

* An impaired life annuity offers higher rates for individuals with certain medical conditions that are likely to be life-shortening. Impaired life annuities are likely to be fully underwritten and the annuity provider will make a detailed investigation of the applicant’s medical history.

What are the two main factors that affect annuity rates?

 

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Conventional annuities are the most widely used annuity products. They provide a guaranteed level of pension income based on a basis agreed when they are set up. There is however a second type of annuity: investment-linked annuities.

Investment-linked annuities provide a pension income which depends on the performance of the underlying investments. They are normally linked to unit-linked funds or with-profit funds chosen by the annuitant. As such the pension income paid can go up or down depending on how the investments perform.

Unit-linked annuities

With a unit-linked annuity the pension fund buys units in a unit-linked investment fund and the income is based on the...

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...isk that the income could fall due to low bonus rates.

If the actual bonus rate matches the chosen rate the income will stay the same for the next year. If the rate exceeds the chosen rate the income will increase for the next year. If the actual rate is below the chosen rate the income will decrease for the next year and the base annuity rate will for the next calculation be lower.

It is possible to provide a guaranteed minimum income that will not be affected by growth rates.

If a with-profit annuity had an ABR of 5% and an initial income of £10,000, calculate the new base annuity if a bonus of 3% was declared.

 

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As well as including options for the member’s own pension income, such as annual pension increases, secured pensions can include benefits payable on the member’s death. Of course, these benefits all come at a cost and the larger they are the more impact this will have on the member’s own pension.

There are 3 main death benefit options:

Dependants’ pensions

Pension guarantees

Value protection.

Dependants’ pensions

Secured pensions can be set up to provide a continuing pension to one or more of the member’s dependants on their death. A dependant is defined as:

A person who was married to the member at the time of the member’s death (this includes partners in civil partnerships)

A person who was married to the member when the member first started to receive a pension but who was divorced from the member before the date of the member’s death (again this includes partners in c...

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...alments for the balance of the guarantee period.

Value protection

A new feature introduced by the simplified regime is the facility for lump sum death benefits to be paid from secured pensions to a wide range of beneficiaries (not just dependants). This is intended to address the traditional concern that annuities offered poor value for money on death.

The facility is also known as annuity protection (or, where scheme pensions are involved, pension protection). The maximum annuity (or pension) protection lump sum death benefit that can be paid is the original crystallised value of the pension minus the total pension payments received to the date of death, less a 55% recovery tax charge. Up until 6 April 2011, annuity protection was available only up to age 75 but this age restriction has been withdrawn.

What is the required term for which dependants’ pensions must be payable?

 

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An alternative to a secured pension is a drawdown pension which allows members (or dependants) to draw a pension income directly from their pension fund rather than using the fund to buy a scheme pension or lifetime annuity. Drawdown pensions are only available to defined contribution schemes and there is no requirement for the rules of the scheme to offer an unsecured pension option.  The pension commencement lump sum is paid in the usual way when the benefits are crystallised but the remaining fund continues to be invested. 

The previous pension fund withdrawal rules (unsecured pension and alternatively secured pension) were replaced from 6 April 2011 by the new pension drawdown rules governing capped drawdown and flexible drawdown, with the new possibility of deferring lump sum payments beyond age 75.

Pension drawdown can be in the form of either capped or flexible drawdown. We will look at capped drawdown in this section and flexible drawdown in the following section then later look at short-term annuities and drawdown death benefits.

Capped drawdown

Capped drawdown replaces both of the p...

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...age of 55, could have faced a problem when taking income from the receiving scheme. However, changes introduced in 2011 by HMRC (and backdated to April 2010) corrected this, allowing income to be paid from the new scheme without incurring unauthorised payment charges.

Transition to capped drawdown

For individuals drawing USP who do not attain 75 until on or after 6 April 2011 their existing maximum income limit applies until the earlier of the following:

The end of the current five year review period

The first scheme income year anniversary following transfer to a new drawdown provider

The first scheme income year anniversary following the 75th birthday, or if already aged 75 from the first anniversary on or after 6 April 2011.

Where a member/dependant was in receipt of an alternatively secured pension (ASP) prior to 6 April 2011, their benefits became subject to the new drawdown pension rules including the income limits with effect from 6 April 2011.

With what frequency must the maximum income limit available under capped drawdown be reviewed?

 

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From 6 April 2011 individuals over the age of 55 that meet the Minimum Income Requirement (MIR) of at least £20,000 per annum will be able to drawdown an unlimited amount out of their crystallised pension funds, although flexible drawdown from protected rights benefits was not permitted. From 6 April 2012, protected rights ceased to exist. The amount drawn will be treated as income for tax purposes.

To enter flexible drawdown individuals will self certif...

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...ar in which they make their declaration. They can make contributions in later years, but these will all be subject to the annual allowance charge.

The pension commencement lump sum may now be paid after age 75 where an individual has elected to set aside or designate funds for drawdown pension at the same time even if they decide to take no income.

State the types of income that do not count towards the MIR.

 

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A member can use part of their capped drawdown fund to buy a temporary annuity known as a short-term annuity. The annuity must be payable at least once a year and whilst it can be level or increase it must normally be guaranteed not to reduce other than in the same specified circumstances as those for a lifetime annuity.

The maximum term for a short-term annuity is 5 years and on expiry anoth...

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...maximum income allowed from the capped drawdown fund. As such the maximum short-term annuity income when added to any other income taken from the drawdown fund must not exceed that which could be received under capped drawdown. Any excess over this limit will be an unauthorised member payment.

What is the maximum term for a short-term annuity?

 

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Drawdown death benefits

If the holder of a pension plan dies while in drawdown pension the fund can be used in one of 4 ways:

It can be returned to the deceased's beneficiaries as a lump sum, subject to a 55% recovery tax charge;

It can be used to provide an annuity or scheme pension for dependants;

It can be used to provide drawdown pension for a dependant with the income limit based on the dependant’s age. If the dependant dies later, the balance of the fund will be paid as a lump sum, less the 55% recovery tax charge;

It can be used to provide a charity lump sum death benefit (without the 55% tax) in respect of a member/dependant who dies while in receipt of drawdown pension before or after age 75. It can only be paid where there are no surviving dependants of the member/dependant and the member has nominated the charity.

Where it is paid in respect of the death of a dependant taking drawdown pension benefits there must be no surviving dependants of the original member and the charity must be nominated by the original member (or in the absence of any such nomination by the dependant).

A ...

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...fund falls in value, the problem is worsened;

Charges tend to be relatively high, given the need to administer the funds and the withdrawals. There is also an on-going need for advice and any associated charge for this.

Critical yield calculation

The critical yield calculation is an attempt to show the investment returns required from a drawdown pension arrangement to match the income that could be provided by a conventional lifetime annuity from the same provider. The critical yield takes into account both mortality drag and the additional costs of drawdown pension. It does however assume that throughout the period of drawdown pension neither the underlying annuity interest rate nor the annuity mortality basis will change, which is quite an assumption to make.

Typically a critical yield based on a maximum pension fund withdrawal will be 2% to 3%pa above the annuity’s underlying interest rate. For example, if the underlying interest rate is 4% the critical yield will normally be in the region of 6% to 7%.

What does the critical yield calculation show?

 

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Regulatory requirements

In August 1998 the regulator at that time, the Personal Investment Authority (PIA), issued a guidance note (Update 55) on the calculation of critical yields for income withdrawal (the predecessor to drawdown pension). This guidance remains in force today.

Update 55 laid down 2 critical yield bases:

Type A critical yield : this is the gross return required from a drawdown pension investment to provide and maintain an income equal to that which the equivalent conventional lifetime annuity can offer;

Type B critical yield : this is the return needed to provide and maintain a selected level of income. This is helpful in understanding the sustainability of a certain level of withdrawals but makes no real comparison with the annuity alternative.

The PIA said that type B illustrations could not be supplied in isolation; each had to be accompanied by a type A illustration. The FCA prefers type A illustrations to be client-specific but allows standardised tables to be used. Type A illustrations must show annuity purchase at...

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...m income that can be withdrawn under an alternatively secured pension after age 75 is significantly less than the maximum that applies before age 75.”

Adviser knowledge levels

In Update 55, alongside the critical yield guidance, the then regulator (the PIA) stressed that advisers involved in the income withdrawal market (now drawdown pension) had to have:

Awareness of such matters as financial strength, types of annuity, the advantages of occupational schemes and the structure of investment funds. Awareness is defined as sufficient breadth of knowledge to put product advice in the right context;

Understanding of such matters as the structure of annuities, phased retirement, death benefits, mortality drag, investment matching and the calculation of critical yields. Understanding is a greater depth of knowledge than implied by awareness.

The Update went on to say that advisers should be aware of developments affecting the market.

Which 2 critical yield bases did Update 55 lay down?

 

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A phased retirement strategy allows an individual to take their retirement benefits in stages as they are needed. This can be particularly helpful to replace lost income for those looking to gradually ease into retirement from full time work.

Traditionally, personal pension plans were split into a series of arrangements or segments to support phased retirement strategies. However, this hasn’t been strictly necessary since 2001 when partial vesting of single arrangements became possible.

Aside from allowing a gradual move into retirement, phased retirement has the advantages of:

Generating very tax efficient income as this is partly provided from the tax-free pension commencement lump sum (PCLS)

Allowing different tranches of income to be set up on different bases to meet changing needs

Leaving part of the fund actively invested with growth potential

Generally providing better death benefits than full retirement.

Phased retirement can involve the gradual purchase of annuities, a gradual move into drawdown or a bit of both. It is all about targeting an income level and phasing benefits into payment as needed to meet that target following regular reviews.

Phased annuity purchase

As with any phasing strategy the starting point is for the member to decide how much income they want (after tax). Part of this income will be provided from the 25% PCLS with the balance coming from the taxable annuity. The adviser or provider will perform the necessary calculations.

At the start of year 2 the client’s target income needs are reviewed and further benefits are crystallised to provide the additional income. Again part of this income will be provided by the 25% PCLS generated from the newly crystallised benefits. The adviser or provider will again perform the necessary calcul...

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...t £100,000)

Are prepared to actively invest and carry investment and mortality risk

Do not need immediate access to the maximum PCLS

Can accept variations in their pension income and afford to delay crystallising benefits

Are looking to maximise death benefits and use their pensions for estate planning

Can afford the administrative, investment and advisory costs that come with an active phased retirement strategy.

Phasing – advantages & disadvantages

The main advantages of phased retirement are:

Tax efficiency - phasing can provide a very tax efficient income stream;

Flexibility - phasing is much more flexible than conventional annuity purchase allowing income and annuity bases to be varied to adapt to changing needs;

Investment growth - as part of the fund remains actively invested this gives potential for real investment growth;

Death benefits - uncrystallised funds can normally be paid as a tax-free lump sum on death. Even death benefits from crystallised funds can be tailored to an extent to meet specific needs.

The main disadvantages of phased retirement are:

Lump sum - there is no immediate access to the PCLS, it is received in phases;

Investment risk - as part of the fund stays invested there is a risk that investments might fall. This means that pension income could be lower than expected;

Interest rate risk - interest rates may fall during phasing, reducing the annuity income that can be secured;

Costs & on-going management - charges are generally higher than with secured pensions and phased retirement strategies need to be actively monitored and reviewed regularly.

Why would you describe phased retirement as being capable of producing a tax efficient income?

 

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