As clients reach the point in their life when they begin to rely more on their investments and savings rather than earned income, they will find that there are a number of options which need to be considered carefully. These notes will discuss the various choices available under pension arrangements – whether these have been arranged through an employer or privately.
These notes are not intended to be of a highly technical nature and individual advice must be taken before deciding how best to proceed with crystallising benefits arising from pension plans.
Successive governments have tinkered with pension legislation over the last three or four decades and anyone who has been investing in pension arrangements throughout their working career will find that there are a number of technicalities that need to be grappled with. These are best dealt with on an individual basis and the depth of expertise at Fiducia Wealth Management Limited can be called on to provide the best technical solutions.
Types of Pension
There are a number of ways in which pension arrangements can be categorised, but a good starting point is to consider whether a pension plan is Defined Benefit (DB) or Defined Contribution (DC). These used to be referred to either as final salary or money purchase schemes respectively. A classic example of a DB scheme is The Civil Service pension scheme. Very similar arrangements are available to teachers and other public sector workers and a reducing number of large private employers such as British Telecom.
Most private companies are now seriously considering whether they can afford to continue with their DB schemes as the potential costs and liability can be huge. Most small to medium sized enterprises have already given up their DB schemes in favour of DC schemes where the costs and liabilities can be contained.
A DB scheme nearly always favours the employee at the expense of the employer.
A DC scheme generally does not include the very expensive guarantees of a DB scheme. A DC scheme can be summed up as ‘You get what you pay for’. The more or less that is invested (and investment performance achieved) governs entirely the benefit which can be produced.
The options at retirement under a DB scheme are fairly limited, simply because the benefit is defined at outset. In rare circumstances it can be appropriate and possible to transfer a fund from the security of a DB scheme and achieve the greater flexibility of a DC scheme.
Tax Free Cash
It is interesting to note that with the introduction of ‘pension simplification’ legislation in 2006 what had been known as Tax Free Cash was renamed as Pension Commencement Lump Sum. Whether this means that the Government ultimately plans to dispense with the tax free nature of the lump sum is a matter for speculation. However, one of the first choices you will have to make is whether or not to draw this lump sum.
Generally, it is nearly always better to take as much cash from a pension plan as is possible. Apart from the additional flexibility of having cash to do with as you will, rather than the discipline of regular income, it is also possible to invest cash which can generate income on more tax-favourable terms. Pension income is taxed as earned income and some investment income can be taxed at a lower level.
That is very much a generalisation and we frequently see circumstances where the best advice is not to take cash but to take pension instead. One such example is where under a DB scheme, a level of pension has to be given up in exchange for tax free cash. Depending on the terms offered, it may be better not to commute pension for the maximum level of cash.
Again as a rule, it is possible to take 25% of a pension fund as tax free cash. You may have been entitled to a larger proportion under previous pension legislation, in which case if you want to maximise a cash payment, it would be worth checking. In some DB schemes, the tax free cash may be limited to a lower proportion of the fund. Again, it may be worth checking to see if the scheme rules will allow that proportion to be increased, and on what terms.
Apart from the limited options on tax free cash and timing of receiving your pension, a DB scheme will provide very little other flexibility. The remainder of these notes will therefore apply to DC schemes. Remember that a DB scheme can be transferred into a DC scheme, but rarely the other way around.
There are three main alternatives to choose from when selecting the method of securing pension income. It is also possible to use a mixture of all three and also phase in the drawing of pension, and so in practice the scale of choice is very wide. Under each main option, there is a wide range of individual choices that have to be made.
1) Lifetime Annuities
Most people who have invested in pensions, reach retirement and accept the Lifetime Annuity which is being offered by the pension provider. This is rather like going through life buying your entire household, motor and any other insurance from the same insurance company. It is highly unlikely the company with which your pension fund is invested will be suitable to provide an annuity.
It is for this reason the Financial Service Authority (FSA) actively encourages pension plan investors to take their entitlement to the open market and purchase an annuity from the best provider.
The annuity market is fairly fluid with a number of providers vying for the top position in the tables. Large insurance companies may increase their annuity rates from time to time as a means to attract new business for cash flow purposes. At any one time certain providers may offer the best rates for a particular type of annuity but not for others. For example, at the time of writing the best provider for a Single Life Non Escalating Annuity is different to the best provider for a Joint Life Escalating Annuity. It makes sense therefore to select the type and style of annuity before actually choosing the provider.
The key decisions that need to be made when choosing an annuity may be summarised as follows:
- Single Life. This type of pension will be payable for the remainder of the annuitant’s life, whether that extends for a few months or a few decades.
- Joint Life. A couple (ie husband and wife, civil partnership or unmarried partners) can have an annuity which will continue at the same level until the last of them dies.
- Reversionary Annuity. Here the annuity reverts to a lower level (perhaps 50% or two-thirds) on the annuitant’s death and is then paid to the survivor for the remainder of his or her lifetime. Generally, these are appropriate for husband and wife situations, but for example it is possible to include other potential dependants such as a housekeeper or even a future wife or husband.
- Guaranteed Period. Usually, five or 10 year guarantee periods are available. By way of example, this means that with a monthly annuity with a five year guarantee, if the annuitant died say after only 12 months, then the value of the further 48 months would be payable to the estate.
- Non Escalation. An annuity can be paid on a level, non escalating basis throughout the annuitant(s) lifetime. This arrangement generally provides the highest initial annuity, but obviously the income is exposed to the risk of future inflation.
- Escalation. It is possible to receive an annuity which escalates by either a fixed percentage each year, such as 3% or 5%, or one that is linked to RPI.
- Investment Linked. A few annuity providers offer income which is linked to the performance of a particular investment fund. While these have the potential of providing above-inflation increases in income, as annuitants linked to the Equitable’s With-Profit fund discovered to their cost, the value of the income may fall as well as rise.
- Payment Frequency. People tend to think of annuities as being paid monthly, but it is quite possible for them to be paid, quarterly, annually, half yearly or even termly (3 times a year). The ultimate choice comes down to a matter of convenience and usually, the difference between say a monthly annuity and an annual annuity is simply due to the annuity provider being able to hang on to your money for a lesser or longer term.
- Guaranteed Annuities. Some older pension arrangements (1980’s and earlier) had guaranteed annuity rates. Generally conditions apply to these rates and usually it would be necessary to draw the pension in a certain style or form – monthly, single life, non escalating for example. Taking these guaranteed annuities is always worth considering, as the initial income can be two or three times more than what is currently available on the open market.
Unsurprisingly some insurance companies do not always make it clear that a guaranteed annuity is available, and so it is always worth double checking before proceeding.
- Impaired Life Annuities. Lifetime Annuities are generally based on an actuary’s view of how long the population at large is likely to live. For example if it is known that the life expectancy for an average 65 year old is to age 87 then annuity rates can be set accordingly, in the knowledge that some people will die much sooner (a bonus to the provider) and some will live much longer (an additional cost to the provider). It is now quite common for annuity providers to offer to medically underwrite annuitants so that if they can be expected to have a shorter life expectancy, they can be offered a higher annuity rate. Smokers are an obvious example but even minor medical conditions can lead to improved annuity rates.
It is reckoned that about 40% of people buying annuities could improve on the terms offered, and in some cases the enhancement can be 20% more in the annual income. A more serious medical condition might be better served by means of income drawdown, or a reversionary annuity.
As can be seen there is a wide range of choice when it comes to selecting the right annuity. The vital point to remember is that once a decision has been made as to which annuity you purchase, the decision cannot be reversed. If you select a level annuity and inflation runs away into double figures, you may rue the day. If you take a reduced pension initially in order to make provision for your potential widow(er) and he or she pre-deceases you, then that money will be wasted.
The purchase of an annuity can be such a momentous decision that it is sometimes preferable to find a way to defer it.
2) Income Drawdown
An alternative to using your accumulated pension fund to purchase an annuity is to draw a level of income out of the fund. The income you draw is taxed as earned income while the un-drawn fund remains in a tax-advantaged environment and will hopefully continue to grow in value. Under the current rules, there are two types of income available: Unsecured Pension and Alternatively Secured Pension.
Unsecured Pension can start at any time from age 50 (55 from 2010) and may last up until age 75. The amount of income drawn can change from one year to the next and can range from nil to the maximum. The maximum is broadly 120% of what could otherwise be provided as an annuity. Unsecured Pension may continue until age 75, at which time either a Lifetime Annuity must be purchased or income can continue to be drawn under the Alternatively Secured Pension rules.
Alternatively Secured Pension is restricted to a maximum of 90% of the FSA annuity tables and a minimum of 55%.
One of the great attractions of drawing income from a pension fund, rather than buying an annuity while part of the pension fund remains in place, is that it can potentially be inherited by beneficiaries. Under Alternatively Secured Pension (ie after age 75) the tax and charges that can be made against the remaining fund make this prospect much less attractive (unless the intention is to ultimately pass the fund to a charity).
Drawing income from the fund provides great flexibility and if the fund is invested well, it has the potential of providing greater benefits in later years.
The counter argument of course, is that if the remaining fund is not invested well, it has the potential for reducing income in future years.
Drawing income from the fund provides the extra flexibility and the chance to defer a decision about the right sort of annuity to purchase. The cost of this flexibility is increased investment risk and this needs to be weighed carefully against the straightforward purchase of an annuity.
3) Short Term Annuities
Another way of deferring the purchase of a lifetime annuity is to buy one for a fixed term, usually five years. These are not as widely available as lifetime annuities but will generally provide the same sort options in terms of style and features. A Short Term Annuity will provide a flow of regular income together with a guaranteed value at the end of the term. At that point, it would then be possible to purchase either another short term annuity (so long as there were at least five years until age 75), commence drawing income from the fund under the unsecured pension provisions or purchase a Lifetime Annuity.
Short Term Annuities can provide good value for money if you are uncertain about inflation or the necessity of providing for a dependant, and in many cases, it can be argued that they provide better value than a Lifetime Annuity.
This isn’t so much another option, but more a combination of partially deferring and partially using one of the other options, to secure the shape of income which is most suitable for you. In its most basic form, phased crystallisation takes place when a proportion of a pension fund is crystallised. For example, if the total pension fund amounted to £250,000, the member could crystallise, say £100,000 to provide tax free cash of £25,000 with the remaining £75,000 being used to provide income either under Unsecured Pension or an annuity purchase. The balance of £150,000 would remain uncrystallised until such time as further cash or income is required. While that is a very basic form of phasing in crystallisation, it is possible to use much more sophisticated mechanisms to phase in an increasing level of income.
Imagine pension funds worth in total £500,000. If these were used to purchase an annuity, you might expect a rate of about 6% – say £30,000 per annum. After basic rate tax, that would amount to around £23,000. If instead, the £500,000 was phased in, it would only be necessary to crystallise say, £92,000. 25% of that would provide £23,000 as tax free “income”, leaving £477,000 still invested. In the following year, depending on how much income you needed, a further tranche of the fund could be encashed, generating more tax free “income”. This could then be subsidised by drawing income from the part of the fund you have crystallised, and so on.
DEATH BEFORE OR AFTER CRYSTALLISATION
The purpose of these notes is to provide an overview of the options arising out of pension funds. A consideration in all of these cases is what will happen in the event of ultimate death – either where this occurs before or after (or in the case of Phased Crystallisation – during) crystallisation. We will provide separate notes on the intricacies of Inheritance Tax on pension funds and where making provision for potential beneficiaries is of concern, specific and individual advice must be taken.
Suffice to say at this stage, that in recent years, HMRC have hardened their attitude towards the use of pension plans as a form of Inheritance Tax planning. Whereas perhaps formerly, it was possible to defer crystallising retirement benefits in the knowledge that your retirement fund could pass to your beneficiaries free of tax, this may no longer be the case. Any indication that a pension fund has been deferred in order to secure a benefit for beneficiaries is likely to be attacked by HMRC.
Until quite recently, there was an alternative method of converting a pension fund into income known as an Open Annuity. This seemed to provide useful benefits to some clients in some circumstances, but unfortunately, the pension simplification rules which were introduced in 2006 made these no longer viable.
It seems likely that in the coming months there will be further innovations which may be of interest to clients and we will of course review all options as they arise.