Overview
There have been many different versions of Drawdown over the years.
For plans set up prior to 6th April 2015, the most common type was:
Capped Drawdown - 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 and the current gilt yield. This maximum current limit is broadly equal to 150% of a single life annuity that you could have purchased at that point. There is no minimum limit.
For individuals who took out these plans prior to April 2015, they will continue to run as they are, providing income is kept below the 150% of GAD rate. Where this is the case the £60,000 annual allowance (2023/2024) for new money purchase pension contributions will remain. For high earners (income in excess of £200,000 p.a.) or for those who have already flexibly accessed other pension plans, the annual allowance may be lower.
However, if more income than the 150% limit is taken, the plan automatically ‘tips into’ Flexi-access Drawdown and will trigger the money purchase annual allowance. Once triggered, any future money purchase pension contributions will automatically be limited to a £10,000. You will also not be able to undertake any future carry forward payments into money purchase pension schemes.
The policyholder can also request for the plan to be converted into a Flexi Access Drawdown if they wish.
From 6th April 2015
Flexi Access Drawdown – this operates in the same way as Capped Drawdown though there is no limit on the income taken. After you have taken your entitlement to the tax free lump sum at outset (usually 25% of the policy value), you can choose to take as much or as little of the remaining pot as you wish and it will be added to any other income you have in that tax year to determine the income tax rate that will apply.
Please note that if you draw any income from this plan, your future money purchase pension contributions will be limited to a £10,000 maximum Annual Allowance.
Tax-Free Cash
Most types of pension plan have the option of taking a tax-free cash lump sum before exchanging the residual fund for a series of payments.
Ordinarily up to 25% of the fund – subject to a lifetime cap of £268,275 - may be taken as tax-free cash, however if the pension funds are or were part of an Occupational Pension Scheme or the individual had applied for transitional protection, then the available tax free cash may be greater.
Tax Free Cash must be taken at outset and once drawn; there will be no further entitlement.
Income
A pension income does not have to be taken from the Flexi Access or Capped Drawdown options but if this is required, income is taxed as earned income under the PAYE system.
Death Benefits
On death pre 75 the funds remaining in the plan will be paid out tax free whether they are paid to the beneficiary(s) as a lump sum or an income.
Those aged 75 and over who haven't yet started their pension, or are taking a drawdown pension will be able to pass on their remaining benefits to any beneficiary who will then be able to take it as a beneficiary’s drawdown pension or beneficiary’s annuity or as a lump sum taxed at their marginal rate of income tax.
Advantages
- You are able to take all of your tax-free cash lump sum entitlement at outset.
- You do not receive a set income but are able to vary it to suit your personal circumstances, to supplement other sources of income or you have the option of taking it all at outset.
- You are able to mitigate your liability to personal income tax in certain years.
- You have the potential to benefit from good investment performance in a tax-efficient environment and to exercise control over your own investment portfolio.
- There are flexible death benefits
Disadvantages – Capped & Flexi-access Drawdown Pension
- You may run out of money and have no pension left.
- Benefits are means tested by the DWP.
- High income withdrawals may not be sustainable during the deferral period.
- Taking large withdrawals may erode the capital value of the fund, especially if investment returns are poor and a high level of income is being taken. This could result in a lower income when the annuity is eventually purchased and could also affect the long term financial security of your spouse/partner.
- The investment returns may be less than those shown in the illustrations.
- Annuity rates may be at a worse level when annuity purchase takes place. Although annuity rates generally increase with age, they have fallen dramatically during the past 15 years with only a small increase more recently. This trend may continue.
- A careful investment portfolio needs to be constructed which will involve some investment risk. This means the fund value could fall which could affect your future income levels.
- Withdrawing too much income in early years may have an adverse effect on preserving your pension purchasing power or preserving the capital value of your fund.
- Increased flexibility brings increased costs and the need to review arrangements on an on-going basis.
- There is no guarantee that your future income will be as high as that offered by an annuity purchased today.
- You may feel the prospect of the future higher income does not compensate for the known income available from an annuity now and for the rest of your life.
- The Financial Conduct Authority (FCA) has particular concerns in relation to mortality risk. If you purchase an annuity, you may benefit from a cross subsidy from those annuitants that die relatively early. This cross subsidy is not present with Drawdown Pensions and so to provide a comparable income, a higher investment return will be required. The impact of mortality can be expressed as an annual percentage rate by which the net investment performance of the remaining personal pension fund would have to exceed the interest rate implicit in an annuity in order to break even. This effect has become known as the ‘mortality drag’.
- The charges are explicit whereas under an annuity they are inherent in the annuity rate offered.
Inheritance Tax Issues
The Government has confirmed that IHT will not typically apply to death benefits from pension schemes. They will however, be monitoring this issue so that pension schemes do not become a vehicle used solely for IHT avoidance.
Suitability
Both Capped and Flexi-access Drawdown (including combination plans) would be generally suited to the relatively sophisticated investor, who is capable of fully understanding the risks involved.
The contract can be used as a useful tax planning tool and a means of accessing pension fund tax free cash without having to take the full taxable income.
