Retirement in depth

Annuity alternatives

Personal Finance and Savings

For those without a final-salary pension scheme the most common way to produce an income in retirement is to buy an annuity. Many appreciate the certainty of income that this provides, but the main drawback is the lack of flexibility and perceived poor value. As a result, those fortunate enough to have accumulated a substantial pension fund may prefer to opt instead for either income drawdown or phased retirement.

At the moment, investors who opt for one of these schemes can only defer the purchase of an annuity until they reach age 75. But when the new pension rules come into full effect on A-Day – 6 April 2006 – pension holders will, for the first time, be able to choose not to buy an annuity at all.

Income drawdown

Income drawdown is available on some personal pensions and certain money purchase occupational schemes. Anyone wanting to take advantage of this facilitywho does not have the right kind of scheme would need to transfer to a suitable arrangement such as a self-invested personal pension (SIPP).

Drawdown schemes tend to structure each pension into 1,000 equal-value segments with the pension assets remaining fully invested until the plan holder requires some retirement income. When this is the case, he or she simply has to cash in some of these segments. The structure allows the investor to take out up to 25 per cent of their fund value as tax-free cash with the balance remaining fully invested but available to provide an income if necessary.

Under the current rules it is possible to move into drawdown from age 50 – rising to 55 by 2010 – though at 75 it becomes compulsory to use the remaining pension fund to buy an annuity. To prevent the fund paying out too much income and leaving nothing for the annuity, the government has imposed limits on income withdrawals. At present the maximum is equivalent to the income available from a conventional single-life annuity, while the minimum is 35 per cent of that amount. These rates are currently calculated with reference to the annuity rate tables published by the Government Actuary’s Department (the GAD tables) but after A-Day pension providers will instead use the comparative annuity rate tables published by the Financial Services Authority (FSA).

Tom McPhail, head of pension research at IFA Hargreaves Lansdown, says that after A-Day the income limits will be widened to between zero and 120 per cent of the annuity rate. “This will increase the appeal of drawdown as it opens up the possibility of taking out the tax-free cash and not drawing out an income,” he says. “Deliberately not drawing a pension in this way may, however, be deemed to be taking advantage of the inheritance tax rules and may result in a tax charge, although the position has yet to be clarified.”

Risks and rewards

Drawdown is one of the most flexible retirement options since the income can be varied each year subject to the annual limits. In particular, the freedom to choose what level of income is taken each year will help those who want to carry on working on a part-time basis while supplementing their wages. Additionally, the pension holder is able to keep control over the assets in their fund for longer and the benefits on death could be greater than if the fund had been used to buy an annuity.

The flipside, however, is that there is no guarantee that the unsecured income will be greater than if the fund had been used to buy an annuity on retirement. The position can be adversely affected by falling annuity rates and poor investment performance. Costs are also higher and if too much income is withdrawn the fund may run out too early.

With these points in mind McPhail says that drawdown is ideal for those who want to pursue investment opportunities and who want flexibility in their income, tax planning and death benefits. “It is most suitable for people with pension funds of £200,000 or more who have some tolerance to investment risk. Typically, they will also have some assets outside their fund, so they are not completely dependent on the pension income.”

Phased retirement

The second means of deferring an annuity purchase is phased retirement. As with income drawdown this is usually only suitable for those with substantial pension funds – those worth £200,000 or more. Again this is not available on all pension schemes so you may have to switch to a suitable personal pension or SIPP.

With phased retirement the pension fund is moved into annuities in stages so as to build up a regular retirement income over time. This income is supplemented with tax-free cash from the fund.

The pension scheme is once again structured in smaller segments and these can be used at any time between ages 50 – rising to 55 in 2010 – and 75, to generate the income. Each arrangement can provide up to 25 per cent tax-free cash, with the balance being used to buy an annuity at the best rate available at that time. As more segments are used in this way the regular pension income increases while the remaining fund stays invested.

Steven Brady, a director at IFA Chartwell Investment Management, says that usually clients go into phased retirement for a combination of reasons. “It tends to be people with assets outside of the pension fund, possibly those moving from full-time to part-time work rather than going straight into full retirement,” he says. “It is a particularly attractive option for higher-rate taxpayers with significant cash held outside the pension fund and for those looking for death benefits.”

The appeal for someone working in a limited capacity post-retirement is that the number of segments encashed in any year can be varied so as to generate the required level of income.

Phased retirement is also extremely tax-efficient, especially for higher-rate taxpayers, as in the early years a high proportion of the annual income comprises tax-free cash, with only the annuity element subject to income tax.

Family benefits

The death benefits on this type of scheme can be especially tax-efficient. “When the pension holder dies there is the option to return the remaining unused segments of the pension fund in full as a lump sum to the beneficiaries without the 35 per cent tax charge that applies to the remaining income-drawdown funds on death. Normally there are no inheritance tax consequences either,” says Brady. “This is a very useful feature and will protect the pension fund assets for a good five or six years after going into phased retirement.”

The main risks are that poor investment returns or delaying the annuity purchase may result in a lower level of income. In addition, initial and ongoing charges are usually higher than those associated with a conventional annuity, since continuing advice is essential to monitor the investment performance of the fund and the income requirements. An even bigger deterrent for many investors is that with phased retirement you cannot take your tax-free cash in one large lump sum.

“The majority of clients not going for an annuity prefer drawdown to phased retirement as they can then get the maximum tax-free cash when they retire,” says Brady. “People like the flexibility of withdrawing this money from their pension fund, especially if they have debts such as a mortgage still to pay off.”

One way to get round this restriction is to combine phased retirement with income drawdown, which gives the maximum benefits under the current rules. A phased income drawdown plan takes the form of a personal pension divided into different segments. It offers the most flexible way of taking income, since each year this could comprise a combination of tax-free cash, an annuity and income withdrawals, though the total would be subject to annual minimum and maximum limits. This option is available from many providers – your IFA should be able to help you find the right one for your needs.

Alternative secured pension

One of the most significant rule changes in the pipeline is that anyone reaching 75 after 5 April 2006 will no longer have to use their remaining pension fund to buy an annuity. Those in income drawdown will instead be able to switch their pension fund at 75 into an alternative secured pension (ASP) where the assets can remain invested. In principle, this option will also be available to anyone with remaining uncashed segments in phased retirement, but this presupposes that pension providers will support this complex combination.

As with the new drawdown rules there will be no requirement to draw an income from an ASP if it is not needed, while the maximum that can be taken will be restricted to 70 per cent of the annuity rate of a 75-year-old. For someone taking the maximum income under drawdown this could result in a significant drop in living standards. Moving from 120 per cent to 70 per cent of the current best single life rate – currently £1,025 per year for a fund of £10,000 – would reduce your income from £1,230 to £717 a year, though this may be a more realistic figure to avoid running down the capital value of the fund.

Inheritance issues

Many investors have been angered by the requirement to buy an annuity at age 75, largely because of inheritance issues, since conventional annuities cannot be passed down from generation to generation. Tim Whiting, head of financial planning at IFA Bestinvest, says sidestepping this requirement will undoubtedly be a major factor in favour of alternative secured pension. “Passing assets on to dependants is already a key reason for the appeal of drawdown and this is likely to be a big player in ASP.”

Whiting explains that under the current rules if the pension scheme member dies while still in drawdown then the next dependant – the spouse or dependent children – can opt to withdraw the whole fund subject to a 35 per cent tax charge, use the fund to buy an annuity, or stay in drawdown until the original plan holder would have been 75. “When this upper age limit goes under the new rules, this could be a much longer-term option,” he says. “The consultative documents implied that this would be a way to transfer assets from generation to generation up to the lifetime allowance of £1.5 million free of inheritance tax. We are however waiting for the tax treatment to be clarified and there is currently a lot of confusion over whether there will be a tax charge on death.”

The tax rules are still being clarified, but it seems unlikely that the Inland Revenue would be so generous as to leave a loophole like this. Yet even if there is a tax charge, ASPs still have much to offer. Unused pension assets can be left to the plan holders’ heirs where they can continue to grow tax-free within the pension-fund wrapper. When the heirs reach 55 the retirement options all come back into play again, allowing them to take 25 per cent of the inherited pension fund as tax-free cash and using the remainder either to buy an annuity or to go into a drawdown plan. Those who elect for drawdown could at 75 join an ASP and in turn bequeath the fund to the next generation.

Planning ahead

Someone approaching retirement whose existing pension arrangement does not offer phased retirement or income drawdown will need to switch into a suitable scheme if they want to take advantage of these arrangements. “Generally even if they have a personal pension we would probably suggest going for a SIPP at retirement,” says Roland Jones, a senior pension consultant at IFA Towry Law. “Where there are no exit penalties or guaranteed annuity rates, often we would look to set up a SIPP pre-retirement.”

The attraction of using a SIPP is the wider investment choice on offer: these schemes can hold investments in equities, bonds, collective funds and, after ‘A-Day’, a wide range of other assets including residential property. Not all SIPPs allow drawdown but those that do are likely to be modified to permit ASP.

Certainly those administered by leading providers such as AJ Bell and James Hay will support this. Insurance companies are less likely to follow suit, although Standard Life is an exception and was one of the first to launch a SIPP that will take advantage of the new rules.

Phased retirement and income drawdown rely on the pension fund being invested appropriately, which is why it is crucial to take good independent financial advice before embarking on one of these schemes. “The idea of moving to safer assets as retirement approaches works well for people who will go for an annuity but is disastrous for income drawdown and phased retirement since these extend the investment horizon for another ten years or more,” explains Jones. “People going for these options need to be comfortable with market risk, since they will need to invest in collective equity funds or even direct equity holdings to generate the critical net yield of 6 or 7 per cent that is required to justify this approach.”