Drawdown Pensions

September 19, 2012

Previously called unsecured pensions, income drawdown pensions allow the pension investor to take income from his pension scheme without having to withdraw the whole fund. This means that the balance of the fund after income has been taken can remain invested for growth, potentially increasing the fund in the future.

For any retiree who does not need to create an income from his pension fund immediately upon retirement, but does have a need for some extra income on top of the income he will already receive.

How an income drawdown pension works

There are two types of drawdown pension:

Flexible Drawdown is only available to those who are already receiving £20,000 a year in pension income (2012/ 13 limit), and has stopped investing into pension plans. There is no lower or upper limit to the amount that can be withdrawn under this type of drawdown pension.

Capped Drawdown is the most common type of drawdown pension. The amount that can be withdrawn is capped to 100% of the single life annuity that a person could purchase based on standard rates. The pension provider will calculate this maximum amount using tables supplied by the Government’s Actuary’s Department. This limit is reviewed every three years, until age 75 when it is reviewed annually. If this withdrawal limit is breached, then a tax charge of between 40% and 55% will be levied on the overpayment.

When can you take income drawdown?

An income drawdown can be initiated at any time after the benefits from the registered pension plan can be taken – this differs from policy to policy but is normally at age 55. Unlike most other pensions, where income must be started before age 75 at the latest, an income drawdown does not have to be commenced. This means that investors can put off taking income for as long as it suits.

Your tax free cash lump sum

As with other pensions, you can take a tax free cash lump sum of up to 25% of the fund. However, though you don’t have to take income from the income drawdown scheme, the cash lump sum can only be taken when the investor starts income drawdown. It cannot be taken later, and is therefore termed a ‘pension commencement lump sum’. Most providers will not allow the delay of taking this cash sum to after your 75th birthday.

Extra flexibility

You don’t have to put your entire pension fund into an income drawdown scheme. You might elect to take part of your fund and buy an annuity to produce an income, while putting the remainder into income drawdown. You could also pay more into the income drawdown scheme or another scheme, providing it is not from pension income (and benefit from the tax relief on contributions).

Tax considerations

Any income taken from an income drawdown scheme will be treated as taxable income, and subject to income tax. Income should be paid to you by the scheme administrator with tax deducted at source under PAYE.

The fund that remains invested (and must be invested) will accrue returns within the pension wrapper. So gains are made free of capital gains tax.

Death benefits

Unless you buy an annuity with certain conditions, such as a spouse’s pension or guaranteed payment term, should you die the benefits (income payments) will die with you. This is not the case with income drawdown schemes.

Funds that are invested in the scheme at the time of death are available to your spouse or dependants. In general the remaining fund can be used by your spouse or dependants to either produce an income or buy an annuity. There are rules that dictate the use of the fund to do this, but subject to those rules the fund can also be converted to a lump sum. However, if this is done, then the lump sum will be taxed at 55% to compensate HMRC for the tax relief paid on your contributions.

Is an income drawdown scheme for you?

If you elect to take an income drawdown, you will benefit from the flexibility that an annuity purchase does not allow. However, your fund will remain invested and so there will be no guarantee of a certain level of income in the future. For this reason the majority of smaller funds will be used to buy an annuity, which will guarantee a certain level of income through life. In fact, due to the continuing investment, and the associated risk to your fund, an income drawdown scheme is rarely used for pension funds below £50,000.

Also, if you are in ill health it may be more advantageous to buy an impaired life annuity. Income drawdown limits are based on standard annuity rates, and impaired life annuity rates will be higher. If this is the case, then you should seek financial advice before deciding upon an income drawdown scheme.

Having an income drawdown scheme also ensures that your remaining pension fund is available for your spouse or dependants to do with what they wish – subject to a tax charge of 55% if commuting to a lump sum payment. If you are in an employer’s scheme and want to take income drawdown rather than income, then you may need to transfer to a personal pension before being able to do so.

Because of the complexity of income drawdown, and the continuing investment necessary, if you are considering this option you will need to discuss your personal circumstances with a financial advisor.