Pensions for the hard of thinking - income drawdown after A-Day
Well, it’s back to basics time again and this time to give you a short and sharp account of how the new Income Drawdown rules will operate after A-Day (6 April 2006). Nothing too technical – just some penny-dropping stuff - short points that I hope will help anyone trying to get their brain cells in order.
‘Income Drawdown’ is what some people do instead of buying an annuity when they ‘retire’. Now, I’ve put the word ‘retire’ in inverted commas there because I’ve begun to lose track of what the word means exactly. In fact I find it easier these days to think about pensions in two phases; the part where you are stashing your money away for the ‘future’; and the part where you access your pension savings and start spending them to keep the wolf from the door later on in life.
The first part, the savings bit, is what everyone thinks about when anyone mentions the word ‘pensions’. The second bit, where we extract our money from our pension schemes, is what we usually refer to as ‘buying an annuity’ – a phrase that would completely bamboozle about 99% of the population.
An annuity is a true insurance product, whereas the savings phase doesn’t have to have anything to do with insurance products. Annuities are real insurance products because they provide an income for life in return for a fixed capital cost at the outset. As people don’t know how long they’re going to live after they retire they’re effectively taking out an insurance policy against living longer than their savings when they ‘buy’ an annuity.
But not everyone is heading for that kind of retirement nowadays. The typical retirement strategy where you go over a cliff edge in your mid-sixties and fall into an end game that requires you to be financially inactive because you can rely on your annuity that you’ve committed all your retirement savings to isn’t everyone’s cup of tea any more. Probably never was, but there weren’t any real alternatives in the past.
Income Drawdown, when it was introduced a few years ago, gave people other options and effectively allowed people to draw an income from their pension savings while still investing the unused funds. This was good as it introduced a real alternative to annuity purchase for people under the age of 75 (the age that those who govern us still deem to be the oldest we can get and still be trusted to manage our own pension savings), but people still had to take some level of income if they wanted to access their tax-free cash entitlement. It also helped if they were a member of Mensa if they wanted to understand it. Because of this, Income Drawdown effectively became a fairly expensive form of self-managed annuity that only the wealthy could really take advantage of, and even then that advantage was quite limited.
Well all this is changing after A-Day with the introduction of the concept of an ‘Unsecured Pension’. Unsecured Pension is a way of ‘crystallising’ [one of the new buzzwords] benefits from money-purchase pension savings schemes before the age of 75. It will apply to all individual money-purchase schemes like Personal Pensions, Stakeholder Pensions and Free-Standing AVCs and the like, and also group money purchase schemes where the trustees change the rules of the scheme after A-Day to allow people to take advantage of the new rules. That’s another good reason for scheme members to start badgering their trustees to get on the A-Day bandwagon, by the way. This idea of designating an ‘Unsecured Pension’ is said to be a bit like Income Drawdown as we know it now, but it isn’t really. There are a number of key differences.
Income may be taken from ‘Unsecured Pension’ as a form of income withdrawal, but it doesn’t have to be. A short-term annuity with a maximum term of five years can also be purchased, but it has to end before age 75 is reached and the person goes officially gaga. If the income withdrawal route is taken the maximum amount of income allowed is 120% of the ‘Basis Amount’ for that year – a bit like Income Drawdown is now if you like. The ‘Basis Amount’ is the highest amount of annuity the amount of pension savings designated to provide ‘Unsecured Pension’ could have purchased with reference to the annuity basis and rates published by the FSA in their ‘Comparative Tables’. But this may be changing soon and going back to GAD rates.
The big news, though, is that the minimum amount of income that people need to take from their designated ‘Unsecured Pension’ funds is zero. Or to put it another way, zilch! This is brilliant, because it effectively breaks the link between taking tax-free cash entitlement and being forced to take an income at the same time, something that’s never seemed sensible to me. In fact, if you want to you can follow this link Scottish Life's views on annuity purchase and financial advice to see what Scottish Life said about this in one of our official lobbying documents from a few years ago where we suggested it would make pensions more popular with people if it was given the Spanish archer [El-Bow].
So, someone in their fifties, say, with a money-purchase pension pot of £100,000 could designate all or some of it to be ‘Unsecured Pension’ and get immediate access to their tax-free cash without any requirement on them to take any income.
An example provided to the BeeHive by some of Scottish Life’s actuarial wizards up in Edinburgh will help. This is the scenario; a guy who is aged 50 after A-Day (but before 6 April 2010) is a member of a money-purchase occupational pension scheme. He’d like to get access to his accrued tax-free cash entitlement so he can buy a sports car, or go on holiday, or something and he’s lucky enough that the trustees of his scheme have changed the rules to allow him to designate funds as available for the payment of ‘Unsecured Pension’ at any age
Well, his pension fund value in this example is £100,000, and let’s say he designates £75,000 of it as being available for ‘Unsecured Pension’ and takes an immediate tax-free cash sum of £25,000. He decides not to take any income from his ‘Unsecured Pension’. He and his employer continue to contribute to the scheme (he doesn’t have to stop work to take retirement benefits after A-Day remember – another brilliant concept). At the age of 65 he decides to hang up his boots and finds that the post age 50 contributions have accumulated to provide another uncrystallised fund of £60,000. He also still has his crystallised ‘Unsecured Pension’ fund that by then has grown, say, to £110,000.
At this stage he decides to purchase an annuity with the lot after all, but first takes the tax-free cash of £15,000 from the uncrystallised bit of his retirement savings. He has no further entitlement to tax-free cash from the ‘Unsecured Pension’ fund.
Now what this will do, apart from making the administration of pension schemes after A-Day a lot trickier, is break the link between the timing of taking income and the taking of tax-free lump sum entitlements. Woof! I’m pretty sure this will become a fairly sexy part of what the new pension environment is going to be all about after A-Day. Any journalists who are reading this BeeLine will doubtless have little trouble in convincing their editors that it’s a great story to run with, particularly in the Sunday papers when people have all day to waste reading, and I hope any advisers reading this will immediately see the value that such good news on pensions is likely to have in their dealings with clients in the future. It’s about time we had some good stories to tell about pensions and there are loads of them in the detail of all this new legislation. As and when we understand what exactly it is we’re reading about as we wade through this stuff I’ll let you in on it too. I can’t be fairer than that…
19 January 2005
This document is based on Scottish Life's current understanding of the Finance Act 2004 and the Pensions Act 2004.