Unsecured Income (AKA Pension Fund Withdrawal and Income Drawdown)

'Unsecured Income' is the latest official way to describe Income Drawdown (also referred to as 'drawdown' or 'pension fund withdrawal'). Henceforth, all references to income drawdown or pension fund withdrawal will be under the title 'Unsecured Income'. It provides a means of taking benefits from pension funds without committing to the purchase of an annuity immediately.

Under the option of 'Unsecured Income' you can choose to take up to 25% of your fund immediately as a tax-free cash lump sum. This option must be taken at outset; otherwise it will be lost.

Instead of buying an annuity with the remainder of the fund, the money remains invested, where it may benefit from investment performance in a tax-efficient environment. You may in this way defer taking an annuity until such time it is considered more appropriate. Before April 2006, an annuity had to be bought by age 75. This is no longer necessary, although the member must move into 'Alternatively Secured Income', a more restrictive form of Unsecured Income. (More on this later).

The word 'unsecured' is used to differentiate between Annuity purchase - where the pension income is 'secured', fixed for life, and carries guarantees to this effect. As 'unsecured' funds remain invested, there are no guarantees that any level of income can be maintained indefinitely.

Under the post 06/04/2006 rules, it is no longer mandatory to take withdrawals from your fund each year; but if you do, they can vary between minimum and maximum limits set at the time the arrangement is started. These limits are derived from tables published by Government Actuaries Department (GAD) and are based on the size of your fund, your age, sex and the current gilt yield.

In broad terms the maximum level of income is currently approximately equal to 120% of what could be provided by a conventional single life, level annuity. The minimum is currently now 0% of the maximum. Income levels are revised by GAD every five years and an appropriate adjustment to the level of income you receive may subsequently be necessary, where the level of income initially selected is either above the maximum or below the minimum revised GAD limits. The new flexibility

See our Pension Fund Withdrawal GAD calculator if you want to calculate the current limits based upon either on size of pension fund or current Gilt yields.

Alternatively Secured Pensions (ASP)

ASP is also similar to Unsecured Income and is available from age 75 when unsecured income must stop. Originally formulated in order to provide pension benefits for those who object to annuities on religious grounds, it is likely to be used mainly by those who wish to avoid being forced to purchase an annuity at age 75. The key points relating to ASI are:

The maximum income is 90% of the GAD factor applicable to a 75 year old.
The minimum income is 55% of the GAD factor applicable to a 75 year old.
The maximum income is reviewed annually using annuity rates from Financial Services Authority tables up to 60 days before the review date.
No Tax-Free Lump Sum can be taken from an ASP. If no lump sum has been taken, this needs to be taken before entering into ASP.
Any surplus funds on death can be passed to a charity, with no inheritance tax liability, or to another family member within the same pension scheme, but this will attract combined tax charges of up to 82% of the fund value. This penal rate is being specifically used to deter individuals passing down pension funds, and should discourage all but the most determined. If there are no family members or no nominated charity, the life insurance / pension administrator will probably pass the funds to a charity of their choice.

Secured Income

If income is not secured on the ASI basis by age 75, then it must be secured either by:

A promise from a pension scheme e.g. a defined benefit scheme (Final Salary Scheme), or
An annuity purchased from an insurance company.

Investment Strategy and Management

The value of the fund(s), the level of income you withdraw each year and the final pension you purchase will all be dependent upon the careful management of the funds remaining invested. It is therefore essential that an investment strategy be adopted when starting this type of plan.

The level of income you choose to take will have implications for the performance of your invested fund(s), and will influence future possible levels of annuity you can buy. Whilst in the short term drawing the maximum possible income from the plan may be very attractive, this may have repercussions in the medium to long term as income from the plan is ultimately dependent on investment returns. For this reason, it is important that income requirements are balanced with a suitable investment strategy, which must be kept under regular review.

Critical Yield

This calculation aims to show, in percentage terms, the investment returns required from an 'Unsecured Income' arrangement to 'match' the income that could be paid by a conventional annuity, a given income stream selected or both. It takes account of plan charges and mortality costs (see below) and assumes that during the period of taking withdrawals, the underlying annuity interest rate and mortality basis will not change.

The effects of mortality upon 'Unsecured Income' plans

One of the important elements determining the price of an annuity is the life expectancy of the annuitant when the annuity is started. Some annuitants will live longer than others and receive more in payments. Others will not even get their money back. This 'cross subsidy' can mean that the person who survives longer than average receives a very high return from the funds invested. This effect is known as the 'mortality drag'.

Within 'Unsecured Income' plans, as income is drawn directly from the fund, there is no 'cross subsidy'. To compensate for this, additional investment returns are required. Where maximum withdrawals are being taken, it is estimated the additional investment return required to be about 1% per annum at age 60, increasing to 2% per annum at age 70.

What happens if you die whilst taking 'Unsecured Income' ?

There are several options available to your nominated survivor if you die while taking income withdrawals:

Receive a cash lump sum, subject to a tax charge of 35%.
Purchase an annuity for the survivor.
Continue taking income withdrawals from the plan.

Taxation Issues

Income withdrawals are subject to income tax.
If, on death, the remaining fund is paid as a lump sum, a tax charge of 35% is applied.
Generally, any lump sum will be paid free of inheritance tax but, in certain situations, the Inland Revenue may apply such a tax.
When tax free cash is taken at outset and not utilised, it may be included in the value of your estate and therefore increase any potential inheritance tax charge.

Advantages of Pension Fund Withdrawal

You are able to take the full tax-free lump sum entitlement at outset.
The pension funds from which you take income withdrawals remain invested, therefore you retain control of your investment portfolio and potentially benefit from the growth provided by the investments selected.
It gives the flexibility to either phase and/or defer annuity purchase.
Income may be varied, between set limits, to suit your personal circumstances.
The facility to vary income levels may provide scope to mitigate your personal liability to income tax in certain years.
The value of death benefits may be more attractive than annuity purchase.

Disadvantages of Pension Fund Withdrawal

Future investment returns are not guaranteed and the value of the pension fund may fall. This may therefore result in a lower total income than if an annuity was purchased at outset.
Annuity rates may be lower in the future. This posed real issues when there was compulsion to purchase an annuity at age 75, but there is now the option to postpone this indefinitely.
High withdrawals of income may not be sustainable during the income withdrawal period and may also reduce the amount of any potential annuity.
The higher the level of income withdrawal chosen, the less that may be available to provide for dependants, particularly when the original fund is small and/or investment returns are poor.
Increased flexibility brings increased administration costs. Charges are likely to be higher than those relating to the purchase of a conventional annuity and may increase in the future.
It is possible that the level of income selected at outset may need to be decreased or increased to comply with new limits arising from the five-year review.
The value of death benefits may not be as attractive as phased retirement or combination of phased retirement and 'Unsecured Income' options.

For whom might Pension Fund Withdrawal be a suitable option ?

For those who need the maximum tax free cash but do not require all the income that an annuity would provide.
For those who are not entirely dependent on the income from the pension plan and can therefore afford to see fluctuations in its level.
For those who understand the degree of risk involved and can afford to take such risks because, for example, they have substantial investments outside the pension plan.
For those who are not married, given that the death benefits compare favourably to annuity purchase, where survivor pensions for anyone other than a spouse (or civil partner) may be difficult to arrange.
For those who are suffering ill health, although careful comparison should be made with any available impaired life annuity.
For those who do not wish to be 'locked' into buying additional benefits that are not required. For example, some pension schemes require a widow(er) pension to be purchased, which will be of no benefit if there is no spouse, or the spouse is in poor health.

Occupational Pension Fund Withdrawal

Occupational Drawdown was an alternative to Personal Pension Drawdown particularly for those who had failed the 'maximum transfer test', or were are entitled to more than 25% tax-free cash under the old Occupational Pension scheme rules, which has always been the limit on a Personal Pension Income Drawdown plan.

Under the new pension rules, these type of arrangements are likely to dwindle away, due to the fact that there is now one common set of rules applicable to all pension arrangements.

NOTE: This document is intended to provide a brief overview of the subject. It should not be read as a recommendation to use any particular product, as it does not take into account individual circumstances and attitudes.