Pensions can be complicated things, particularly with the number of different options out there and the different schemes that you can use to take it out. Rather than uhmm-ing and ahh-ing over the number of options available, making an informed decision about which scheme is right for you is essential, so having a sound understanding of all the different options is key.
It is also important to realise that value of your pension can fluctuate. This means that you might get back less than you have contributed over the years, so it is important to choose wisely. Income drawdown pensions offer you the freedom to access your pension whenever you need to in the form of either a lump sum or income payments.
What you do with your pension is an important decision to make, and a decision that shouldn’t be made lightly as often you won’t be able to change your mind once the decision has been made. You should make sure you understand all of the options and the risks and make an informed decision based on this.
What is an Income Drawdown Pension?
There were, until 6th April 2015 two types of income drawdown pension, each with resounding positives as to why that scheme is the right one for you. The options were capped drawdown and flexi-access drawdown pensions.
Capped Drawdown Pensions
Since this 6th April 2015, the taking out of capped drawdown pensions has been closed to new applicants and was a way of taking a proportion from your pension pot as an income. The money within your pot would be invested in funds in order to do this. This product is no longer available to new customers but if you already have a drawdown pension such as this, it’s important that you understand the rules associated with it.
Capped drawdown pensions continue under their existing rules. However, customers should bear in mind that any excess on the drawdown ‘cap’ that the pension holds can negatively affect the tax relief you are entitled to on future pension savings.
In capped drawdown pensions, the pension pot you hold, after you have chosen to access and withdraw your tax-free amount is wisely invested into a fund to ensure that you are paid an income. Depending on the performance of the fund you have invested in, this income can fluctuate both up and down and is a taxable income. Such pensions do not guarantee an income for life.
Capped drawdown pensions are reviewed on a 3-year basis if you are under the upper-limit age of 75 and then, after this point, reviewed on a yearly basis. In terms of what you could be entitled to as an income, capped drawdown pensions carry a maximum income of 150% of what a person in good health, of the same age as you, could claim from a lifetime annuity. This income is worked out by using Government Actuary Department rates, or GAD rates.
Upon review, whether this be every three years or yearly, a new maximum income is calculated for you, based on how much remains within your fund and on the GAD rates.
The other type of Income Drawdown Pension is referred to as Flexi-access drawdown pension and has been available since the same date. Flexi-access drawdown pensions are different from capped pensions because of the fact there is no income limit on what you can take from your drawdown fund.
Older funds would have allowed you to take up to 25% of your pension pot as this tax-free lump sum, and the rest is moved into a fund where you are able to take taxable income whenever you need to. This can ensure you are able to take a regular income to support yourself through retirement.
Contrary to this, flexi-access drawdown pensions allow customers to take unlimited (to the value of their pension pot) but taxable withdrawals from their fund. This combined with the fact that the pension is transferable upon your death makes it a particularly attractive option to people wanting a more versatile pension choice.
If you die before you turn 75 and you have taken out an income drawdown pension, any money that is left in the fund when you die can be passed onto a beneficiary of your choice. Any money that they take out, whether as a lump sum or else as an income, will be tax-free.
This money must be paid out within two years of the provider becoming aware of your death and if this limit is missed, then the income will lose its tax-free status and will be paid to the beneficiary’s income as normal. After the age of 75, your nominated beneficiary will receive the income and be taxed on it.
Who can get an income drawdown pension and how much does it cost?
Income drawdown is an option offered when someone takes pension benefits from a scheme referred to as a money purchase arrangement. Anyone wishing to benefit from an income drawdown pension scheme such as the flexi-access scheme should make an initial transfer out of their pension scheme to a money purchase agreement.
A person can choose to go into a flexi-access drawdown from the age of 55, or earlier if ill health conditions are met or else if the lower protected pension age applies. Flexi-access drawdown pensions can be used alternatives to purchasing a particular annuity and the options available to you as a customer depend entirely on the scheme you decide to use.
Whether you are a suitable candidate for drawdown pension depends on a number of factors. An income drawdown pension could be attractive to a customer who wants to be able to access their tax-free lump sum but doesn’t have need for a pension income – perhaps because they continue to receive an income from employment.
If an individual is in poor health, income drawdown could be considered in addition to impaired health annuities as a means of providing an adequate pension income.
Advantages of Income Drawdown Pensions
There are a number of benefits to flexi-access drawdown schemes:
Freedom and flexibility
Taking out a flexi-access drawdown pension as opposed to an annuity allows you increased flexibility concerning withdrawals from your pot whenever you need. Ensuring that you carefully balance the benefits attached to this flexible withdrawal scheme with a sustainable income strategy that will see you all the way through your retirement.
This flexible drawdown scheme could be used in the same way as a savings account or another investment, giving people complete control over how much they save or else withdraw from their pension pot.
Benefits – death and control
Your pension fund, in the case of your untimely death, can be completely transferred over to your beneficiary, dependant or successor, depending on your personal circumstances. You remain entirely in control of the money you have contributed, unlike is the case with annuities where the insurance company who has issued the annuity keeps any remaining cash when you die.
Income drawdown allows people of the retirement age to retain ownership of their annuities and gives them a choice with what to do with it.
There are no additional charges on withdrawals if you decide to dip into your fund and withdraw more than your initial amount. You can take the full amount of your fund over two or more years to minimise your tax liability and ensure that you only take enough out of your fund to last the rest of your lifetime.
Drawdown products are complicated, and the cheapest product may be more hassle than they are worth. When assessing schemes look for the ones that give you the most value not just the most affordable.
What are the disadvantages?
Pushing yourself into a higher tax-band
A lot of people are more than willing to work beyond their retirement age and instead choose to take their pension through a drawdown scheme and work alongside this. Doing so could actually put you into a higher tax band, leaving you with less money than you would expect. Customers with drawdown pension schemes should consider when the best time to use them, from a financial perspective, would be.
Having the freedom to dip in and out of your pension pot with no cap on the amount you are allowed to withdraw could be detrimental. There is always the possibility that your pension pot will run out money if you take too much, too quickly, as well as the fact that you may live considerably longer than you expect. Taking too much money out of the scheme in the earlier years of the policy ensures that it won’t last as long, and you may fall short of the basic living requirements in later years.
Sequence risk, otherwise known as ‘sequence of returns risk’ considers the investment performance of the pension pot immediately after taking retirement, whenever the investors stop paying their contributions into it and start to commence their drawdown. Some investments don’t perform as well as they should do so it is important to review your investment regularly.
Underlying investments can suffer heavy losses which can ultimately affect how capable an individual is of funding their retirement later down the line. Speaking to a regulated financial advisor about your investment ensures that you keep on top of its ability to perform.
The amount you can contribute to your fund if you are still working decreases
If you are still working and earning an income after you have taken income through drawdown pension, the amount of money that you can contribute to your pension plan will be limited to the reduced Money Purchase Annual Allowance of £10,000 per year.
Making wise investment or withdrawal choices are essential.
The value of the pension fund may well go up in value as well as down in value; poor investment choices could result in the pension holder not having sufficient funds available to purchase annuities at a later date, which would be equivalent to the amount they would have been entitled to, had they taken it from the outset.
There is also no guarantee that these annuity rates will improve in the future – they could end up being lower when the pension holder eventually decides to purchase their annuity than the current rate.
Alternatives to Income Drawdown Pensions
Drawdown pensions, and more specifically, flexi-access drawdown pensions, are one of a number of options available to the general public with regards to how to use their pension pot to provide their income after choosing to take retirement.
Ultimately, drawdown pensions are complicated products and should be researched thoroughly before taken out. If you decide that it’s not the perfect scheme for you, there are alternatives out there that could provide a more specific service. You can use your pension to buy a guaranteed income for life through the form of an annuity. There are different lifetime annuity options and features to choose from that can determine how much income you would be able to take as a lump sum.
If you so wish, you could also choose to close your pension and cash it in to take the full amount in one go. Usually, the first 25% of the pot is completely tax-free, but the rest will be taxed at your highest tax rate.
While this option may sound appealing, there are actually a number of risks associated with it, and it may leave you with a high tax bill and without a reliable income during your retirement years. Getting financial advice before cashing in your entire pension pot is advised.
Another alternative could be to combine your options to come up with the perfect pension plan for you, taking lump sums and income at different times according to your personal needs. You can even choose to carry on putting contributions into your pension plan up until you reach the age of 75.
The combination of options that is right for you can depend on;
- How old you are
- Whether you are in good health
- When you decide to stop or else reduce your working hours
- How many financial dependents you have
- The size of your pension pot and other savings
- How likely your circumstances are to change in the future
- Your attitude towards risk.
Anyone wishing to discuss their pension options can do so with a financial adviser to ensure that they are getting the best possible deal.