Click here to print this page

 

Unsecured Pensions - more detail

 

We suggest you read our Unsecured pensions / Income Drawdown overview before you read this section

Detailed aspects of Unsecured Pensions

Further contributions

Once your pension funds have moved into an Unsecured Pension, you cannot pay further contributions into that contract.

Transfers

Subject to certain rules, you can transfer your Unsecured Pension fund between providers.

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 an alternative to annuity purchase, such as Unsecured Pension, 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 when you eventually buy an annuity. This is known as “mortality drag”.

Critical yields are illustrated by product providers using a common prescribed basis. There are two types (A and B).

Type A – the growth rate needed on the “drawdown” investment sufficient to provide and maintain an income equal to that obtainable under an equivalent immediate annuity.

Type B – the growth rates necessary to provide and maintain the actual level of income chosen.

In simple terms, the critical yield is the rate of return required by the income drawdown fund to provide and maintain an income at least equal to that which could be provided if an annuity had been purchased at the outset instead. This is also known as Critical Yield Type A.

It takes into account mortality drag and the additional cost involved in an Unsecured Pension and, crucially, assumes that throughout the period of withdrawal the underlying annuity interest rate and mortality basis will not change.

When an income is actually being taken from an income drawdown plan there is a second critical yield figure, sometimes referred to as Critical Yield Type B. This shows the rate of return required to provide the selected level of income. It is particularly significant if you are looking to maintain that income throughout the full term of the plan.

Both figures are important as they show the returns that your investments need to achieve so have implications for the underlying investment portfolio. If the critical yield is higher than the expected returns on long term gilts, it will generally be necessary to have a reasonable exposure to other asset classes, for example equities.

You should be aware that, if the overall investment return turns out to be lower than the critical yields, your income will be lower in the long run than it would have been, had you bought an annuity at the outset. If the investment return reaches or exceeds the critical yield, (or if annuity rates increase), the eventual income you can purchase via an annuity will be greater.

Conversely if annuity rates reduce, the investment return required to achieve a comparable income will be greater, and the critical yield figure will increase. It is therefore important to monitor the returns of the underlying funds to ensure that the critical yield is being achieved.

If investment performance is consistently less than critical yield B, the current income may be unsustainable and may need to be reduced or changes may need to be made to the investment portfolio. If investment returns are less than critical yield A, you are likely to end up with a lower income than if you had bought an annuity at outset, assuming unchanged annuity rates.

The critical yield is an important consideration in deciding whether or not Unsecured Pension is an appropriate investment vehicle or not. Once established, it is then necessary to decide how the funds will be invested in order to achieve the required returns. Generally, if long term income is the requirement, the Unsecured Pension route will only prove to be more effective in total income terms if the investment return generated is sufficient to cover:

  • The investment return on current annuity rates, plus
  • Mortality drag, plus
  • The additional costs involved in an Unsecured Pension arrangement as opposed to an annuity.

Death Benefits

If you die during the fund withdrawal period, the following options are available to your dependants:

  • Continue to take withdrawals in the same way. Income tax is charged on the withdrawals as earnings in the usual way.
  • The maximum income level is calculated at the date of death using the rate from the GAD tables appropriate for the dependant.
  • Buy an annuity, which is taxable in the usual way.
  • Take the remaining fund as a lump sum, with liability to tax at 55%.

In correspondence with the ABI, the Capital Taxes Office has confirmed that, as a general rule, there will be no IHT liability on a lump sum benefit paid under trust on the death of the member where:

The decision to take Unsecured Pension or to decrease the level of income taken was made for ‘commercial and retirement planning reasons’, and the individual was in normal health and not aware of any ill-health when making the pension fund withdrawal decision and survives at least two years afterwards.

“Ill health” in this context means terminal illness or health such as to render the individual uninsurable.

Protected Rights

As with withdrawal from other pension sources, the income withdrawals must be within prescribed limits, as set by the Government Actuary’s Department.

If death occurs during drawdown a qualifying spouse may either:

  • Continue income withdrawals
  • Purchase an annuity

If there is no qualifying spouse, the residual fund will be paid to an individual nominated by the member, or to the member’s estate. A tax charge of 55% will be levied, and as the payment is non-discretionary, it may be subject to Inheritance Tax.

Strategic reviews

Three-year reviews are mandatory assessments but your investment strategy should be reviewed frequently, ideally on an annual basis. Any significant life event or change in investment conditions should lead to a reappraisal.

Unsecured Pension may also be available for Protected Rights funds.

Variants of Income Drawdown

There are variants of income drawdown in particular Capped Drawdown and Flexible Drawdown. These are explained below.

Capped Drawdown Pension - An annual income can be taken from the invested pension fund, if required. This income may vary between limits, set at outset by the Government Actuary's Department (GAD). The maximum limit is reviewed every 3 years up until age 75 and then annually thereafter. The figure is derived from tables published by the Government Actuaries Dept (GAD) and is based on your fund size, age, sex and the current gilt yield. This maximum limit is broadly equal to 150% (from 27 March 2014) of a single life annuity that you could have purchased at that point. There is no minimum limit.

Please note that Capped Drawdown Pension can be set up as a Phased Capped Drawdown plan and would operate in a similar way to Phased Retirement mentioned previously. The difference under this option is that instead of buying an annuity to provide income, encashment of a certain portion of the fund would be made to purchase a series of Capped Drawdown Pension plans.

Flexible Drawdown Pension – There is no maximum limit with this type of plan allowing immediate access to the remaining funds. You must be able to prove however, that you have a secured pension income already of at least £12,000 pa (reduced from £20,000 as at 27th March 2014) from other pension arrangements, to select this option. The residual fund if taken in this manner would be subject to the usual income tax rates.

In order to use Flexible Drawdown Pension an individual must:

- Satisfy the Minimum Income Requirement.

- Have paid no contributions (or had any contributions paid on their behalf) in the same tax year in which flexible drawdown is to be taken.

To be eligible the individual must also not be an active member of a defined benefit or cash balance scheme.

Whilst in Flexible Drawdown, any future contributions made into a money purchase scheme by the individual or their employer will be subject to an Annual Allowance tax charge taxed at the highest marginal rate, resulting in no financial gain. This tax charge will also apply to individuals who build up benefits in a Cash Balance or Defined Benefit arrangement.

 

NEXT STEPS

Learn about the more complex options that you haven't read about yet:
Unsecured Pensions (also known as Income Drawdown), or
Phased Retirement or
Third Way options

or return to the start of the annuities guide.

However if you feel that you need some help from a financial advisor, then visit our section on obtaining financial advice, or our page on Laterlife selected services and associated advice.

 
Bookmark










Over 50s Travel Insurance
Obtain a quote online