Sometimes referred to as Guaranteed Drawdown / Guaranteed Income Options.
Overview
Against a background of increased volatility in stock markets, perceived poor rates being offered for Lifetime Annuities, concerns regarding future inflation and the fact that people are now living longer, the retirement market was in need of a new type of product. These new plans are commonly known as ‘Third Way’ products and they are already very popular in the US and Japan.
Essentially they fit in between a Lifetime Annuity and a Drawdown plan as they offer the chance to still participate in stock market growth but with guarantees attached to either income, capital or both.
Whilst each specific product does differ in its features, the ‘Third Way’ pension is usually structured in one of two ways:-
Annuity – this option is commonly structured as a fixed term, value protected annuity plan, typically running for 5 years at a time, with the option to include guarantees to protect maturity values or the level of income. These products tend to offer the ability to alter income levels between certain limits and importantly, also allow the facility to provide a lump sum on death.
Flexi-access Drawdown – the second type of Third Way plan is structured as a Drawdown Pension plan but with the option to apply a guarantee to the initial investment so that your fund value will never fall below what you originally paid into the plan. Some plans also allow all or a portion of any growth in the plan’s value to be locked in and a new minimum guaranteed level is then set. Finally, the option to select a guaranteed level of income is also commonly available.
Under both of the above options, you can choose to immediately take a tax-free cash lump sum and then, instead of buying an annuity, leave the remainder of the fund invested in a tax-efficient environment.
If you use either of these options, any future money purchase pension contributions will automatically be limited to a £10,000 per annum. You will also not be able to undertake any future carry forward payments into money purchase pension schemes.
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 may be taken as tax-free cash, subject to a lifetime cap of £268,275, 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 than 25%. Tax Free Cash must be taken at outset and once drawn; there will be no further entitlement.
Income
No maximum. This income is taxed as earned income under the PAYE system.
Death Benefits
If you die whilst in a Third Way product the death benefits can differ depending on how the particular plan you are using has been set up e.g. annuity based or flexi-access drawdown based. You therefore need to check the specific product terms and Key Features.
Advantages
- You are able to take all of your tax-free cash lump sum entitlement at outset.
- Unless a guaranteed income is selected, you do not have to receive a set income but are able to vary it to suit your personal circumstances to supplement other sources of income.
- 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.
- You are able to add a safeguard in the form of a guarantee to limit any drop in your fund value and some products allow gains to be locked in.
Disadvantages
- 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 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 slight increase more recently. This trend may continue.
- A careful investment portfolio needs to be constructed which will involve some investment risk. If capital guarantees are not included then 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 and the addition of guarantees bring 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.
- You may be prevented from withdrawing your chosen level of income due to the action of the GAD limits.
- 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 Unsecured Income plans 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’.
- If you opt for an annuity version of the Third Way plan the charges are typically built in to the annuity rates offered. If you decide to choose a Drawdown Pension version of a Third Way plan, the charges are added on top.
- Both of these are generally more expensive than a traditional annuity or Drawdown pension plan.
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 for IHT avoidance.
Suitability
Both versions of this Third Way plan would generally suit a relatively sophisticated investor, who is capable of fully understanding the mechanics of the plan and 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 and it importantly allows the individual to defer annuity purchase until their future plans are clearer.
The availability of guarantees allows this type of contract to be suited to more cautious individuals who would not normally suit a Drawdown Pension plan however, the guarantees do come at a cost.
