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Flexible
income
Since A-Day from 6 April 2006 a member can select a
compulsory purchase annuity or pension
annuity by the scheme members age of 75 or an alternatively
secured income (ASI)
to draw an income.
Up to age 75 the member can take a flexible income to
phase in retirement. This can be achieved from pension
withdrawal in the form of pension
drawdown.
The income from drawdown can be any amount
from £0 per annum up to a maximum of 120% of the
highest annuity payable for a person of their age. Both
defined income
such as from a final salary pension and flexible income
from a money purchase scheme will be able to take a tax
free lump sum.
For phased retirement the lump sum will be realised over
time when part of the pension fund is used for a compulsory
purchase annuity. In contrast pension drawdown will realise
all the lump sum initially with a variable income paid
thereafter.
Money purchase schemes
Where a scheme member can contribute to a pension fund and the
benefits at retirement age are uncertain, as they are dependent
on the size of the funds under management, but the contributions
are known then this is referred to as a defined
contribution scheme. A defined contribution can be made
to a money purchase scheme and could be operated by an employer
as an occupational
money purchase scheme, a group personal pension or simply
established by a person as an individual policy such as a stakeholder
pension.
Since Pension Simplification from 6 April 2006 the amount of
retirement benefits from a money purchase scheme is limited
to the Lifetime
Allowance which is a total fund of £1.5 million in
2006/07. In terms of contributions the member is limited to
the Annual
Allowance which is £215,000 in 2006/07.
However, tax relief on the contributions is limited to the higher
of 100% of relevant earnings or where tax relief is given at
source, limited to £3,600. There is now no restriction
to the earnings
cap or to the 15% contribution of pensionable
earnings as existed before A-Day.
The limit for contributions such as 17.5% to 40.0% for personal
pensions and stakeholder pensions or 15.0% of pensionable
earnings for members of an occupational money purchase scheme
have been replaced to allow individuals to make contributions
subject to the annual allowance and this gives the individual
the opportunity to contribute considerably more to their retirement
planning.
For all money purchase schemes the retirement benefits can be
taken between 50 to 75 years of age. At age 75 the member can
purchase an annuity after taking a tax free lump sum of 25%
or switch to an Alternatively
Secured Pension (ASP) and draw an income.
The opportunity to defer purchasing an annuity can greatly enhance
the possible income from the pension
fund. However, although the schemes are flexible there is
an associated risk that the value of the underlying assets can
go down as well as up. Nevertheless for those individuals prepared
to take a greater risk, pension withdrawals can give the members
an income in the short term with the prospect of investment
growth in the future.
Pension
drawdown
The Financial Services Authority (FSA) Handbook of Rules and
Guidance, define a pension
fund withdrawal (PFW) and states that in relation to a decision
of a customer, in respect of a personal pension scheme, to defer
the purchase of an annuity and to take either:
•
Income withdrawals
within the meaning of section 630 of the Income and Corporation
Taxes Act 1988 (ICTA)
as amended by section 58 and schedule II of the Finance
Act 1995, and any provisions amending or replacing it;
•
Or payments
made under interim arrangements in accordance with section
28A of the Pension Schemes Act 1993 (PSA
93), as inserted by section 143 of the Pensions Act
1995, and any provisions amending or replacing it;
•
And in respect
of an election to make pension fund withdrawals, a reference
in the rules to a consumer, an investor or a policyholder
includes, after the persons death, his surviving spouse
and/or anyone who is, at that time, his dependent.
The PFW is better known as pension drawdown or phased retirement
and where the pension income must be supported by the critical
yield calculation. Provisions introduced in the Finance
Act 1995 allowed members of personal pensions to select pension
fund withdrawals known as pension
drawdown rather than acquiring a compulsory purchase annuity
with the pension remaining invested in an insurance company
fund.
Pension drawdown allows the member to have more control over
their pension, but must still purchase an annuity at the age
of 75. When the member takes drawdown, commutation to a tax
free lump sum of 25.0% is possible and the balance of the fund
must be used for drawdown. The withdrawal levels are subject
to minima (being 35.0% of the maxima) and maxima based on the
Government Actuary's Department (GAD)
tables on long-dated gilt yields that are reviewed every three
years.
However, it is always possible to take the tax free lump sum
and buy a purchase
life annuity to provide guaranteed income, that represents
in part a return of capital (usually being about 2/3rds of the
income) and the balance of interest taxed at the savings rate
of only 20%. The advantages of annuity
taxation therefore favour a purchase life annuity rather
than pension annuity.
Phased
retirement
Rather than opting for pension drawdown, phased retirement,
also known as staggered
vesting, allows the member to defer drawing all of their
pension benefits and spreading them over time, up to the age
of 75 at which time the balance of the fund must be taken as
a compulsory purchase annuity. Designed to give the member more
control over income at retirement age, phased retirement allows
segments of the pension fund to be drawn when required.
A personal pension plan uses the practice of segmentation
and will consist of up to 1,000 identical but separate segments.
Each time the member draws on a segment, a tax free lump sum
of 25.0% can be taken and the balance used to purchase a compulsory
purchase annuity. The remaining the fund value will remain
invested with the provider. The main advantage is that:
•
It allows flexible pension planning;
•
Allows the phasing in of pension income
with part time work;
•
Lets the individual take their retirement
benefits as a pension
annuity later when annuity
rates could possibly be higher as the member becomes
older;
•
Offers the potential for investment
growth in the remaining fund.
The disadvantage is that:
•
The tax free lump sum will be phased
over time with each segment withdrawn;
•
Inflation,
Interest rates and hence annuity rates could fall further;
•
Investment returns could be poor resulting
in a smaller fund value.
Tax
free lump sum
A tax free lump sum commuted from a pension fund can be paid
to the scheme member at retirement. For a defined contribution
scheme such as personal or stakeholder
pension and occupational money purchase scheme the tax
free lump sum is 25.0% of the fund value.
Since A-Day, the Pension
Simplification rules introduced from 6 April 2006 allow
a tax free lump sum of 25% to be taken from all pension arrangements.
This includes an occupational pension scheme such as a defined
benefit final salary pension, money purchase scheme, Additional
Voluntary Contribution (AVC)
or FSAVC, retirement annuity policy (RAP) and contracted out
protected rights such as SERPS and S2P.
Previous to A-Day, for a final
salary pension or money purchase scheme, this lump sum
would have been derived from a formula based on the members
final salary and number of years in employment. This would
be either two-and-a-half times the pension income at retirement
age or, if greater, 3/80ths for each
year of service up to retirement times the final salary for
the year up to a maximum of one-and-a-half times final salary.
Since A-Day any occupational
pension scheme members that have rights to take more than
25% as a tax free lump sum will automatically retain these
rights within the plan. For a contracted in money purchase
scheme (CIMP)
where the contributions are small, say 2.0% to 3.0% of net
relevant earnings, at retirement
age up to 100% of the fund value could be taken as a tax
free lump sum.
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