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Also known as income drawdown, income withdrawal, pension fund withdrawal, and unsecured pension, drawdown schemes allow you to take an income from your pension fund when you retire without buying an annuity. The bulk of your pension fund remains invested.
The option was only introduced in 1995 following pressure from pensioners’ groups and others to abolish compulsory annuity purchase. Drawdown was a compromise, allowing pensioners the option to make withdrawals from their pension fund without buying an annuity, but still insisting that they buy an annuity before their 75th birthday.
Following the big shake up of pension legislation in April 2006, known as A Day, further changes were made to drawdown to enable people to defer their annuity beyond the age of 75 by taking an Alternatively Secured Pension (ASP) instead.
Alternatively Secured Pensions work in a similar way to unsecured pensions for the under-75s - your money remains invested - but the rules are different.
How does drawdown work?
The concept of drawdown is relatively simple. Just like an annuity you can take 25% tax-free cash from the pension, but rather than buying an annuity with the remaining funds, you withdraw money each year from the drawdown contract. As the bulk of the fund remains invested, if it grows by more than you are withdrawing, then it will increase in value.
The maximum you can take out is equivalent to 120% of the return you would have received from a conventional single life level annuity, but as there is no minimum you don’t have to take any income at all. The maximum income is set for five years at a time and is recalculated at five-yearly intervals, based on your remaining pension fund and your age and gender.
What are the advantages?
Drawdown is flexible in that it allows you to vary the amount of pension you draw each year. You can still take the tax-free lump sum, and if you die what’s left of your fund can be bequeathed to your family. Your fund remains invested so potentially it could grow further, still in a tax efficient pension fund. You can buy your annuity at any time, which may enable you to take advantage of any upturn in annuity rates.
Since, generally speaking, the older you are the better the annuity rates, by deferring your annuity purchase you may get a bigger pension at the end of the day. However, it will be paid for fewer years, so overall your return may not be higher.
What are the disadvantages?
The main disadvantages are that your income drawdown scheme could fall in value, especially if investment returns are poor and a high level of income is taken. Moreover, annuity rates could go down.
There is absolutely no guarantee that you will get a higher pension by waiting than you could have achieved had you bought your annuity on retirement at age 60 or 65, and indeed there is the very real risk that you will not.
Charges are higher for income drawdown than annuity purchase and you, or your professional adviser, will need to monitor your pension fund to keep an eye on investment performance and make changes if necessary.
For all of these reasons, it is generally accepted that drawdown is only a viable option for those with a large pension fund (£100,000 or more), or for anyone who has a secure income from another source and doesn’t need the money that an annuity would provide.
You should also take independent financial advice before entering into a drawdown scheme, for example from one of the specialist advisers listed above.
Mortality Drag
By opting for drawdown you will also lose the beneficial effect of ‘mortality drag’. This is the cross subsidy you get if you buy a conventional annuity on retirement. The pension you get is based on the average life expectancy for a pool of people of your age at the time of your annuity purchase. Some of them will die early, meaning the money that would have paid their pensions becomes available to pay the pensions of the rest. So, there is a cross subsidy from those who die young to those who live longer.
If you defer buying an annuity until much later in life, the annuity pool will be smaller because of those who have died young, and those who are left will have a higher life expectancy. The older you are, the greater your life expectancy becomes. These factors depress annuity rates for older people and go some way towards negating the benefit you derive from the fact that you are buying your annuity at an older age.
What happens at age 75?
At age 75 you can either buy an annuity or you can continue in drawdown by taking an Alternatively Secured Pension (ASP).
ASPs were introduced in April 2006, enabling over-75s to avoid annuity purchase for the first time.
However, the Government made it clear that ASPs were primarily intended for people with religious objections to buying an annuity. For example, annuities are contrary to Muslim Sharia law and are also barred to Plymouth Brethren, who view them as a form of gambling.
This may go some way towards explaining why the Government sought to make ASPs distinctly unattractive to most people by imposing punitive tax charges on death. If you pass on the fund value to family members (other than your spouse or financial dependents) this will incur a tax charge of at least 70%, and potentially as much as 82% if inheritance tax is due.
However, you can leave the fund to charity without any tax charges, and the punitive tax regime only comes into effect if the funds are left to people other than a spouse or financial dependants. If they are used by a spouse then the tax charges do not apply until the subsequent death.
CashQuestions Guide to State Pensions
CashQuestions Guide to Occupational Pensions
CashQuestions Guide to Private Pensions
CashQuestions Guide to Pensions for Women
CashQuestions Guide to Annuities
CashQuestions Guide to Drawdown
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