Uncertain about How to Take Your Pension?

Business Woman chatting to colleague

Are you ready to take your pension benefits but uncertain about how to take your pension? Taking pension benefits has become more complicated for many people as the choices have increased with the addition of pension drawdown. In days gone by when people used to spend the majority of their working lives with the same organisation retirement benefits were pretty straightforward. You would reach retirement age, be given a parting gift by your employer (usually a clock or a watch) and possibly something more useful (like gardening tools) by your colleagues. 

The following month instead of a salary you would receive the first payment of your pension.  Whilst the pension would be very much lower than your previous salary you would receive a state pension at the same time and so you could manage.

 

With more and more companies moving away from providing defined benefit pension schemes the responsibility has passed to the individual to get the best pension they can with the pension fund they have managed to accumulate. At the same time, whilst the new pension freedoms are welcome, they have increased the complexity of the decisions that you need to make.

Benefits from a Personal Pension Plan

When we use the term personal pension plans here we include stakeholder pensions and self invested personal pensions (SIPPs).  There are two main benefits that can be provided by personal pension plans at any time once age 55 has been reached. 

These are a tax free lump sum, technically referred to as a ‘pension commencement lump sum’, of up to 25% of the pension fund and an income from the remainder of the pension fund.

The income benefit

The tax free lump sum is self-explanatory and so your decision will need to be focused on the income element which can be arranged as follows:

  • Purchase an annuity.  This is the ‘secured option’This could be a conventional annuity which guarantees a known level of income for life.  This could provide a level or increasing income, be on a single life or joint life where the income continues to be paid to your spouse in the event that you predecease him or her.  Alternatively this could be an investment linked annuity.  These are usually described as a with profits annuity or a unit linked annuity to reflect the type of underlying investment fund that is to be used.

 

  • Purchasing an annuity is the ‘traditional’ retirement option although there is no need to actually retire in order to take the benefits.  When you take the benefits you are said to ‘vest’ your pension, which is pension speak for crystallizing or starting to take some pension benefit from a pension plan.  When you buy the annuity, you must choose exactly what benefits you want.  You cannot normally change your mind later. 

 

  • Purchase a pension drawdown product. This is the ‘unsecured option’.  This allows you to vary future income levels to fit in with your overall financial plan.  It also allows you to take the tax free cash but then no income initially so that your fund continues to build up during a period of part-time employment or consultancy work.

Phased Retirement

Rather than setting up the whole of your pension at the outset you can use what is called ‘phased retirement’ (also referred to as ‘staggered vesting’) to convert your retirement fund in stages, over a number of years, into income.  Where you gradually purchase a series of annuities this is usually referred to as ‘phased retirement’.  Where you gradually move your pension fund into a pension drawdown product this is usually referred to as ‘phased income drawdown’.

The phased retirement and phased income drawdown options are only suitable for people who do not want the full amount of tax free cash at the outset.

A Conventional Annuity

An annuity is an insurance provider’s promise to pay an income for a set purchase price.  In the context of pensions the income is normally paid monthly for the rest of your life.  After your death, payments could continue to a dependant, such as a spouse, (usually at a lower level).  It can be for a fixed amount or can increase each year, for example in accordance with changes in the cost of living.  It provides certainty and security.

You could take the tax-free lump sum at the outset and reinvest this to generate additional income in retirement.  You could choose to purchase an annuity with this money as well.  This is called a ‘purchased life annuity’, to provide additional income.  Part of the income generated by the purchased life annuity can be paid tax-free. 

In essence annuities are simple, secure and guaranteed. However, annuity purchase is no longer the simple choice it was because of:

 

  • Poor annuity rates – annuity rates simply reflect the current low inflation rates, interest rates, investment returns and the increasing life expectancy of the UK population.  In 1990 Scottish Equitable quoted a level annuity of £14,653 a year for £100,000 purchase price for a male age 65.  In 1999 the same client could have obtained only £8,332 a year from Scottish Equitable.  In 2006 the same client could only have obtained £6,940 from Scottish Equitable. Scottish Equitable is no longer quoting for external annuity business but the best rate available as at May 2020 is £4,615 a year.

 

  • The desire to pass wealth to the next generation – there is no scope with an annuity to pass assets to children or grandchildren.

 

  • The desire for investment control or at least a say in the investment of increasingly large pension funds.

 

  • The desire for a more flexible solution to cope with the realities of an uncertain life.

 

The chart below, provided by William Burrows (http://www.williamburrows.com) plots annuities and gilt yields over the last 25 years and shows just how far annuity rates have fallen.

A close up of a map

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More Sophisticated Annuities

When considering the purchase of an annuity it is important to be aware of other types apart from conventional annuities.

 

  • Unit Linked Annuity – you accept a lower initial income in exchange for sharing in the potential investment growth.  Some future growth can be discounted to give you a higher initial income level.  If investments do well, this could provide you with an increasing income in the long term. However, if investments do not do as well as expected, your income may fall.

 

  • With Profit Annuity – similar to the Unit Linked Annuity but the insurer’s With Profit Fund is used.  This is a definite alternative to an RPI linked annuity because of the higher starting income level, even with no allowance for a particular annual bonus level, and the greater likelihood of growth over a long period.

 

  • Impaired Life Underwritten Annuity – higher annuities are available for people suffering from particular conditions, the most common are special rates for smokers and those who are clinically obese.  This recognises that their life expectancy is lower than a healthy person, so grants them a higher income during their lifetime.  Where these are arranged on a joint life basis there may be no noticeable improvement in the rate as the underwriter may take the view that whilst the male has a serious heart complaint his healthy wife is likely to outlive him and continue to receive a good portion of the pension benefit.

 

  • Market Segmentation Annuity – another recent development is the introduction of annuity rates based on your occupation and postcode.  For example, a manual worker in Yorkshire will be given a higher annuity rate than an office worker in Surrey.  This type of annuity is likely to see additional categories being introduced over the years ahead.

 

Annuity options

A conventional annuity will pay you an income for life.  The amount of income payable will depend on such factors as your age and health, the amount of your pension fund and the options selected. 

Level or Escalating? – A level annuity pays the same amount of income year after year.  It pays a higher income compared to the initial starting income available under an escalating annuity, which will take a number of years to catch up and exceed a level annuity.

An escalating annuity, on the other hand, is designed to increase each year.  The greater the level of escalation chosen, the lower the initial income.  It is possible to select a fixed rate of increase each year, alternatively, you can choose to link increases to reflect changes in inflation

The mathematical argument in favour of a level annuity is strong given the large number of years that the escalating annuity will take to catch up.  On the other hand you will feel poorer every year with a level annuity as inflation reduces its buying power.

Spouse/Dependant’s Pension – You can arrange for an annuity to continue to be paid to your their spouse or dependant if you predecease them.  Usually, the annuity will reduce, so that the spouse/dependant will receive perhaps half or two-thirds of your own annuity.  Depending on your relative ages, you may need to give up a significant part of your own pension if you wish to provide for your dependants.  However, for many people this will not be an issue as their main concern is the financial security of their loved ones.

A ‘joint life last survivor annuity pays out until the second person of a couple dies.  It is possible for the annuity to continue at the same level to a survivor but most couples elect for an income between one third and two thirds of the original amount.  In a household where one spouse has been a higher earner it could make sense for any annuity purchased by the high earner to continue without reduction to his or her spouse but for the lower income spouse to set up their annuity on a single life basis.

Frequency of Income – You will need to select at the outset how often you want to receive income each year.  Most people choose monthly, but income can usually be paid quarterly, half-yearly or annually.

Income paid in advance or in arrears – Payments can be made either in advance or arrears.  If you opt for monthly income and purchase your annuity on 15th January and receive your first payment on that day, you are being paid in advance.  If your first payment is not made until 15th February, you are being paid in arrears.

With or Without Proportion – When you dies, an annuity with proportion will pay an amount proportionate from the last payment until the date of your death.  This is most valuable when income payments are made on an annual basis.  This option is only available for payments made in arrears.

Guaranteed Annuity Rates – Some annuity providers have guaranteed annuity rates written into their contracts which will provide you with a considerably higher income than would normally be available.  If such rates are available it is often the case that the benefits must be taken in a certain form such as single life, yearly in arrears.  You should always ask for alternative quotes from the provider as they may still be higher than you can obtain on the open market.

Guarantee Periods – Instead of the annuity simply ending on your death, it can continue for a guaranteed minimum period from the start (typically 5 or 10 years) even if you were to die within that time.  Choosing a guaranteed period means that the pension will be lower than a ‘non-guaranteed’ pension but usually only by a small percentage.

Open Market Option – Far too many people simply take the annuity offered to them.  However, you have the right to purchase your annuity from any other pensions office if you can get a better deal.

Pension Drawdown

You no longer have to purchase an annuity when you take the tax free lump sum from your pension fund, or even when you want to start taking an income from your pension fund. Instead, you can put off buying the annuity as long as you wish.

Pension Drawdown was introduced in the Finance Act 1995.  This type of plan is aimed at the more financially aware investor and tends to attract the larger pension funds. 

If you want to take part of your pension fund as a tax-free lump sum you do this before starting to take income from the fund.  The income you take out of your remaining pension fund is taxable. 

Using pension drawdown still allows you to purchase an annuity later in life although the amount you receive could be a lot lower if your pension fund has reduced through the level of withdrawals or poor investment performance.

Pension drawdown enables you to retain control over your pension fund and allows it to continue to be invested in the markets.

Mortality Drag – Annuity providers know that not all annuitants will live as long as expected.  The providers use this ‘mortality gain’ to subsidise current annuity rates.  Therefore those clients who die earlier than expected, subsidise the remaining annuitants.  If you choose to use pension drawdown then you do not benefit from this cross subsidy and effectively take on the ‘mortality risk’ yourself.  The longer you delay annuity purchase, the less you will benefit from the cross subsidy if you eventually buy an annuity. This is known as ‘mortality drag’. 

Critical Yield – The critical yield calculation is an attempt to show the investment returns required from a pension fund withdrawal arrangement to match the income that could be provided by a traditional annuity.

The critical yield takes into account mortality drag and the additional costs involved in pension drawdown and, crucially, assumes that throughout the period of withdrawal the underlying annuity interest rate and mortality basis will not change. 

Clearly the critical yield is an important consideration in deciding whether or not pension drawdown is an appropriate investment vehicle or not.  Once established it is then necessary to decide how the funds will be invested to achieve the critical yield.  Generally, if long term income is the requirement, the pension drawdown route will only prove to be more effective in total income terms if the investment return generated is sufficient to cover (1) the change to annuity rates, plus (2) mortality drag, plus (3) the additional costs involved in a pension drawdown arrangement as opposed to an annuity.

Death Benefits

For information on what happens if you die whilst you still have uncrystallised or crystallised (i.e. in pension drawdown) pension funds please refer to Death Benefits from Pension Schemes.

 


Links to more information about pensions

 

Important

This information does not constitute personal advice and should not be treated as a substitute for specific advice based on your circumstances.

Information given relating to tax legislation is based on my understanding of legislation and practice currently in force. Whilst I believe my interpretation of current law and practice to be correct in these areas, I cannot be responsible for the effects of any future legislation or any change in interpretation or treatment. In particular you are warned that levels of tax and tax reliefs are subject to alteration and, in any case, the value of such reliefs and benefits may depend on an individual’s circumstances.

If you are in any doubt as to whether any course of action is suitable for you, then you should discuss the matter with a suitably qualified independent financial adviser or other specialist.