Unsecured Income/Unsecured Pension
Overview
Under the option of Unsecured Income (previously known as
Pension Fund Withdrawal or Income Drawdown) 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.
An annual income can then 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, which is reviewed every 5 years, is derived
from tables published by GAD and is based on your fund size,
age, sex and the current gilt yield. This maximum limit is
broadly equal to 120% of a single life annuity that you
could have purchased at that point. There is no minimum
limit.
An annuity must eventually be purchased by age 75 or the
remaining funds would move into an Alternatively Secured
Pension which is classed as a Crystallisation Event (see
later in this guide)
Please note that this type of contract can be set up as a
Phased Unsecured Income 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, encashments of a certain portion
of the fund would be made to purchase a series of Unsecured
Income plans.
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, 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
A pension income does not have to be taken but if this is
required, it cannot exceed 120% of the maximum GAD rate.
This income is taxed as earned income under the PAYE system.
Death Benefits
If you die whilst in an unsecured income contract your
nominated beneficiary has a number of different options
available to them:-
a) he or she can take the fund as a cash lump sum (with a
tax charge of 35%), or
b) he or she can buy a lifetime annuity with the fund, or
c) he or she can buy a scheme pension with the fund, or
d) he or she can choose to continue taking unsecured income
until they are 75, or
e) If the dependent is aged over 75 then they could opt to
move into an Alternatively Secured Pension
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, up to a maximum limit, 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.
Disadvantages
● 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. 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.
● You may be prevented from
withdrawing your chosen level of income due to the action of
the GAD limits.
● The Financial Services
Authority (FSA) 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 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
If it is unclear that there were not sound retirement
planning reasons for undertaking unsecured income and death
occurs, the use of the contract may be deemed as an attempt
to circumvent the payment of inheritance tax (IHT).
Furthermore, if you are in ill health and decrease the level
of withdrawals with the intention of keeping the funds in
your plan, thus outside of your estate, this may also be
seen as a deliberate attempt to avoid IHT.
In both cases, the Capital Taxes Office, could issue a claim
and it is therefore vital that should your circumstances or
personal health alter, that you seek professional advice on
this very complex issue before reducing your withdrawals.
The Capital Taxes Office (CTO) recently clarified the
application of Inheritance Tax to this type of pension plan
and the results of their review were essentially that IHT is
unlikely to apply on death, except in the above scenario.
Critical Yield
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
a selected level of income.
Suitability
Both Unsecured Income and Phased Unsecured Income 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.