Pensions and retirement planning

Individuals have several choices when taking benefits from their pension plans. These may take the form of a tax-free lump sum, the ‘pension commencement lump sum’ (PCLS) along with one or more methods of retirement income provision.

From 6 April 2011 un...

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...do not require the full degree of flexibility offered by flexi-access drawdown.

You should be aware that defined contribution schemes do not have to offer all of even any of the flexible access options. This applies to both individual and employer sponsored schemes.

If an individual's total pension arrangements are relatively low in value, it may be possible to convert them into a cash payment.

The trivial commutation option is available when the total capital value of all the member's retirement benefits (both defined benefit and defined contribution, crystallised and uncrystallised) does not exceed £30,000 on the nominated date. The nominated date must fall either on the first day of the commutation period, or in a three-month window ending on that first...

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...nal pension schemes.

Small pots payments can be taken once minimum pension age has been reached  or earlier where there is a protected pension age or as a result of early retirement due to ill health.

It is worth noting that for any small pot(s) payment taken not to be counted towards the £30,000 trivial commutation limit, it/they must be taken before trivial commutation occurs.

How are small occupational scheme pots treated under the triviality rules?

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A pension can either be secured or unsecured. We will be looking at both in the next sections.

The main advantages of secured pensions are:

Security - the member knows what income they will receive;

Simplicity – once the pension is in payment...

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...obvious signs of this changing

There are two types of secured pension: a scheme pension and a lifetime annuity which we cover in the next sections.

What are the two main advantages of secured pensions?

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A scheme pension is a promised pension paid to a pension scheme member by the scheme administrator or an insurance company chosen by the scheme administrator. It can be secured by purchasing an annuity from an insurance company selected by the scheme administrator or can take the form of a pension paid directly from the scheme assets. Either way, it is taxed as income.

All pensions paid from defined benefit arrangements are scheme pensions

Defined contribution schemes can provide scheme pensions but the member must first be given the opportunity to select a lifetime annuity from their choice of insurance company. In practice, because of the practical difficulties in guaranteeing a scheme pension from a defined contribution scheme without purchasing an annuity, it is unlikely that many schemes will offer this option, with large occupational defined cont...

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...(this has not changed from 6 April 2015) and/or pension protection

Can be transferred to another registered pension scheme if the form of the pension does not change

Scheme pensions can only be reduced if the reduction is the result of:

A pension share or other court order (e.g. on bankruptcy) reducing the scheme pension payable

An ill-health pension stopping because the member has recovered

A bridging pension ceasing or reducing at State pension age

A global reduction to all pensions under the scheme (for example, on wind-up)

A requirement of public sector pension regulations, e.g. where a pensioner is re-employed

The scheme administrator paying an annual allowance charge in relation to the member

What three factors determine the level of pension available from a defined benefit scheme?

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A lifetime annuity is a pension paid from a registered pension scheme which has been secured by the purchase of an annuity from an insurance company. It is taxed as pension income.

Defined benefit arrangements cannot offer lifetime annuities. All defined contribution  schemes must offer members the option of a lifetime annuity from the insurance company of their choice. This is known as an ‘open market option’ and means that the fund need not be used to purchase an annuity from the plan provider but can instead be used to purchase an annuity from another provider offering a better rate or a more suitable type of annuity.

The benefits received from a lifetime annuity depend on the size of the fund at retirement, the annuity rates available and the type of pension benefits selected. Until 6 April 2012, it also depended on whether the fund was comprised of protected or non-protected rights. However, from that date, protected rights ceased to exist as a separately designated type of pension and all monies held within a defined contribution scheme are now treated the same way, provided the scheme rules are changed accordingly...

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...e 75. Lump sum payments outside the lump sum allowance will also result in the excess being chargeable to income tax.

Lifetime annuity rules bought before 6/4/2015

Must be paid at least annually for life

Conventional lifetime annuities must normally be guaranteed not to reduce (other than in the specified circumstances detailed below)

Can include ancillary death benefits such as dependants’ pensions, guarantee periods of up to ten years and/or annuity protection

Must not be capable of being assigned or surrendered except in the event of a pension sharing order

Can be transferred to another registered pension scheme if the form of the pension does not change

Conventional lifetime annuities can only be reduced in certain prescribed circumstances, i.e. if the reduction is the result of:

A change in RPI/CPI

A change in the market value of freely marketable assets

A change in an index reflecting the value of freely marketable assets

A change in the bonuses attached to a with profits annuity

Under what circumstances can conventional lifetime annuities be reduced?

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The two main factors affecting annuity rates are longevity and long-term gilt yields.

Longevity

Longevity or life expectancy has improved substantially over the past century, mainly due to better social conditions and advances in medicine. This means that people are living longer and each generation spends more time in retirement. The issue that this creates for insurers is that the annuities they commit to pay will be payable for longer than was the case in the past. As a direct consequence of this, annuity rates have fallen markedly in the last twenty years, albeit having started to increase again over the last three years due to incr...

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...ely on the affluence of the area. Although underwriting is also required for an enhanced annuity, this is done on an automated basis using a points system, rather than being based on the individual’s medical record

- An impaired life annuity offers higher rates for individuals with certain medical conditions that are likely to be life-shortening, such as cancer or heart disease. Impaired life annuities are likely to be fully underwritten and the annuity provider will make a detailed investigation of the applicant’s medical history

What are the two main factors that affect annuity rates?

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Conventional annuities are the most widely used annuity products. They provide a guaranteed level of pension income depending on the basis agreed when they are set up. A variation on conventional annuities is investment-linked annuities.

Investment-linked annuities provide a pension income which depends on the performance of the underlying investments. They are normally linked to unit-linked funds or with-profit funds chosen by the annuitant. As such, the pension income paid can go up or down, depending on how the investments perform.

Unit-linked annuit...

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...= £19.60

New base annuity: £980.29 + £19.60 = £999.89

If the applicant selected a realistic ABR there is the potential for a rising income. If the applicant selected a higher ABR the initial income would be higher but there is a high risk that the income could fall due to low bonus rates.

The provider may offer the option to switch to a conventional annuity.

If a with-profit annuity had an ABR of 5% and an initial income of £10,000, calculate the new base annuity if a bonus of 3% was declared.

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As well as including options for the member’s own pension income, such as annual pension increases, secured pensions can include benefits payable on the member’s death. Of course, these benefits all come at a cost and the larger they are the more impact this will have on the member’s own pension.          

For a scheme pension payable from either a defined benefit scheme or a (large) occupational defined contribution scheme, there are three main death benefit options:

Dependants’ pensions

Pension guarantees

Value protection

A non-scheme pension can also be paid out to a nominee (an individual who is not a dependant who has been nominated by either the member or the scheme administrator) or to a successor, who is an individual nominated by a dependant, nominee or earlier successor.

Dependants’ pensions

Secured pensions can be set up to provide a continuing pension to one or more of the member’s dependants on their death. A dependant is defined as:

A person who was m...

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...e introduced by the simplified regime is the facility for lump sum death benefits to be paid from secured pensions to a wide range of beneficiaries (not just dependants). This is intended to address the traditional concern that annuities offered poor value for money on death.

The facility is also known as annuity protection (or, where scheme pensions are involved, pension protection). The maximum annuity (or pension) protection lump sum death benefit that can be paid is the original crystallised value of the pension minus the total pension payments received to the date of death, and taxed on the recipient as pension income under PAYE if death occurs on or after attaining age 75. If death occurs before age 75 and the lump sum death benefit is paid out within the two-year window following the member’s death, and is within the lump sum allowance, then there is no tax charge. Lump sum allowance excess payments are taxed as the income of the beneficiary.

What is the required term for which dependants’ pensions must be payable?

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An alternative to a secured pension is a drawdown pension, which allows members (or dependants) to draw a pension income directly from their pension fund rather than using the fund to buy a scheme pension or lifetime annuity. Drawdown pensions are only available to defined contribution schemes and there is no requirement for the rules of the scheme to offer an unsecured pension option. The pension commencement lump sum is paid in the usual way when the benefits are crystallised but the remaining fund continues to be invested.

There are two types of drawdown, capped drawdown and flexi-access drawdown.

Capped drawdown

Capped drawdown is only available for those members who were in capped drawdown on 5 April 2015. Since that date, if a member wishes to designate additional funds into an existing capped drawdown arrangement they are still allowed to do so, and their maximum income for their entire capped drawdown plan is recalculated immediately. Care needs to be taken, however, that t...

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...sting one is transferred into it. The member could also choose to re-designate the monies as being in flexi-access drawdown upon transfer, but while removing the income limit this would also trigger the money purchase annual allowance.

In general, where a fund in capped drawdown pension is transferred, the income limits and the review period remain the same.

Where an individual is in capped drawdown and decides to convert it into flexi-access drawdown with their existing provider, the money purchase annual allowance would be triggered when they notify the scheme administrator of their intention to convert into flexi-access drawdown and subsequently take a drawdown pension from that fund in excess of their maximum permitted income. Once capped drawdown has been converted into flexi-access drawdown it cannot be converted back.

With what frequency must the maximum permitted income limit available under capped drawdown be reviewed?

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From 6 April 2015, all existing flexible drawdown plans automatically became flexi-access drawdown plans. The effect of this for those members being re-designated from flexible drawdown is to immediately give them a money purchase annual allowance which they would not previously have had as their annual allowance under flexible drawdown had been set to zero

The key advantages of flexi-access drawdown are that it allows the member to wi...

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...ly unnecessarily high income tax charges on lump sum withdrawals which could be reduced if a more carefully planned process of withdrawals was followed instead. There is also the added risk of fund depletion and the member outliving their pension fund.

When will the money purchase annual allowance (MPAA) be triggered when a member designates monies into flexi-access drawdown on or after 6 April 2015?

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A member can use part of their capped or flexi-access drawdown fund to buy a temporary annuity from an insurance company, known as a short-term annuity. The annuity must be payable at least once a year and it can be set up using either the conventional or flexible annuity rules. The only death benefit it can include is a guarantee period of no more than five years. ...

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...d from the capped drawdown fund. As such, the maximum short-term annuity income when added to any other income taken from the drawdown fund must not exceed that which could be received under capped drawdown. Any excess over this limit will be an unauthorised member payment.

What is the maximum term for a short-term annuity?

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Drawdown death benefits

If the holder (previous recipient) of a pension plan dies while in capped or flexi-access drawdown pension, the fund can be used in one of four ways:

It can be returned to the deceased's beneficiaries as a lump sum, subject to the lump sum being taxed as pension income under PAYE on the recipient if death occurs on or after the previous recipient attained age 75. It will be paid out tax-free if death occurred before age 75 and the death benefit is paid-out within a two-year window following the previous recipient’s death

It can be used to provide an annuity for a nominee/dependant/successor, subject to being taxed as pension income under PAYE if death occurs on or after the previous recipient attained age 75. It will be paid out tax-free if death occurred before age 75 and the death benefit is paid-out within a two-year window following the previous recipient’s death

It can be used to provide continuing flexi-access drawdown pension for a nominee/dependant/successor, subject to being taxed as pension income under PAYE if death occurs on or after the member attained age 75. It will be paid out tax-free if death occurred before age 75 and the death benefit is paid-out within...

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...nnuity in the first place. If the fund falls in value, the problem is worsened

Charges tend to be relatively high, given the need to administer the funds and the withdrawals. There is also an ongoing need for advice and any associated charge for this

Critical yield calculation

The critical yield calculation is an attempt to show the investment returns required from a drawdown pension arrangement to match the income that could be provided by a traditional lifetime annuity. The critical yield calculations take into account both mortality drag and the additional costs of drawdown pension. It does, however, assume that throughout the period of drawdown pension, neither the underlying annuity interest rate nor the annuity mortality basis will change, which is quite an assumption to make especially with the general trend being one of improving mortality rates.

Typically, a critical yield based on a maximum pension fund withdrawal will be 2% to 3% per annum above the annuity’s underlying interest rate. For example, if the underlying interest rate is 4%, the critical yield will normally be in the region of 6% to 7%. 

What does the critical yield calculation show?

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Instead of designating part of the fund to drawdown, making a 100% withdrawal taxed as pension income under PAYE and taking the related tax-free lump sum, a member of a defined -contribution scheme can just take a UFPLS, leaving the rest of their pension arrangement untouched.

To qualify as an UFPLS, it must be payable from uncrystallised funds held in a defined-contribution arrangement, and the member m...

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...they wish, as there is a permissive statutory override to their scheme rules if they want to allow it. Clients who cannot access it through their current provider may be able to transfer to take advantage of UFPLS. It has, however, been suggested that the UFPLS option will allow some defined contribution scheme providers to offer increased flexibility, without the need to provide full flexi-access drawdown.

Conduct of Business Sourcebook (COBS)

Firms must signpost availability of Pension Wise to clients. This is a free and impartial government service, offering guidance (not advice) on defined contribution pension options at retirement. (Pension Wise is part of the Money and Pensions Service (MaPS).

COBS dictates the content required in an open market options statement. This should contain a fact sheet/summary of client’s open market options as well as information about their pension scheme.

A reminder of the OMO statement, sum of money available, availability of guidance and recommendation to seek guidance must be provided six weeks (at the latest) before a client’s intended retirement date

If a retail client asks a firm for a retirement quotation more than four months before a client’s intended retirement date, an OMO statement should be sent (unless one was issued in last 12 months).

Otherwise, the OMO should be sent four to six months before client’s intended retirement date. If a retail client is considering/has decided to discontinue drawdown or use part of a fund for OMO, the OMO statement should be sent (unless one was already issued in the last 12 months).

Retirement risk warnings

Firms must give appropriate risk warnings to clients a...

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...nderlying current annuity investment return (2) is around 4% for market leading rates and the total critical yield (1) is 6%, the additional yield (3) is 2%. The additional yield figure does not vary significantly with underlying annuity investment returns.

Given the fact that flexi-access drawdown with unrestricted withdrawals is now the default drawdown option, it is highly likely that critical yield types A and B will become increasingly irrelevant. 

Adviser knowledge levels

The FCA expects advisers involved in the income withdrawal market to have an:

Awareness of such matters as financial strength, types of annuity, the advantages of occupational schemes, the structure of investment funds and the developments affecting the market. Awareness is defined as sufficient breadth of knowledge to put product advice in the right context

Understanding of such matters as the structure of annuities, phased retirement, death benefits, mortality drag, investment matching, how long term gilt yields can affect income, the need for regular reviews, the calculation of critical yields and the effect of charges and adviser fees on the contract. Understanding is a greater depth of knowledge than implied by awareness

What are the two types of critical yield?

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A phased retirement strategy allows an individual to take their retirement benefits in stages as they are needed. This can be particularly helpful to replace lost income for those looking to gradually ease into retirement from full-time work.

Aside from allowing a gradual move into retirement, phased retirement has the advantages of:

Generating very tax efficient income, as this is partly provided from the tax-free pension commencement lump sum (PCLS)

Allowing different tranches of income to be set up on different bases to meet changing needs

Leaving part of the fund actively invested with growth potential

Generally providing a wider choice of death benefits than full retirement

Phased retirement can involve the gradual purchase of annuities, a gradual move into flexi-access drawdown (or capped where it commenced pre-6 April 2015), periodic UFPLS, or a combination of the three. It is all about targeting an income level and phasing benefits into payment as needed to meet that target following regular reviews.

Phased annuity purchase

As with any phasing strategy, the starting point is for the member to decide how much income they want (after tax). Part of this income will be provided from the 25% PCLS, with the balance coming from the taxable annuity. The adviser or provider will perform the necessary calculations.

At the start of year two, the client’s target income needs are reviewed and further benefits are crystallised to provide the additional income. Again, part of this income will be provided by the 25% PCLS generated from the newly crystallised benefits. The adviser or provider will again perform the necessary calculations but this time they will also have to take account of the income provided from the annuity set up in phase one.

This process is repeated for each year in which the member remains in phased retirement.

Example

Joan is aged 60 and a basic rate taxpayer. She needs a net income of £12,000 a year from her £300,000 pension fund. For the purposes of this example, fund growth after charges is assumed to be 6% per annum and tax rates and allowances are assumed to remain unchanged.

In year ...

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...ed and is usually about more than simply providing a retirement income. To work properly it requires ongoing monitoring and regular (ideally annual) client reviews.

The reviews need to consider:

The member’s income needs

An appropriate investment strategy for the invested funds

The death benefit position

Given this, phased retirement strategies are really aimed at clients who:

Have large pension funds (normally at least £100,000)

Are prepared to actively invest and carry investment and mortality risk

Do not need immediate access to the maximum PCLS

Can accept variations in their pension income and afford to delay crystallising benefits

Are looking to maximise death benefit options and use their pensions for estate planning

Can afford the administrative, investment and advice costs that come with an active phased retirement strategy

Phasing – advantages & disadvantages

The main advantages of phased retirement are:

Tax efficiency - phasing can provide a very tax-efficient income stream

Flexibility - much more flexible than a one-off conventional annuity purchase allowing income and annuity bases to be varied to adapt to changing needs

Investment growth - as part of the fund remains actively invested, this gives potential for real investment growth

Death benefits – wide choice of death benefit options due to the ability to mix and match to meet specific needs

The main disadvantages of phased retirement are:

Lump sum - there is no immediate access to the PCLS, it is received in phases

Investment risk - as part of the fund stays invested there is a risk that investments might fall. This means that pension income could be lower than expected

Interest rate risk - interest rates may fall during phasing, reducing the annuity income that can be secured

Costs & ongoing management - charges are generally higher than with secured pensions and phased retirement strategies need to be actively monitored and reviewed regularly

Why would you describe phased retirement as being capable of producing a tax efficient income?

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An individual’s State benefits will be an important part of their decision aroound when to retire.  How significant their overall pension and non-pension assets are will help determine the bearing their State pension b...

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... the entire lump sum being added to their income.

When an individual decides to defer their basic state pension for 36 weeks by what percentage will it increase in payment when finally taken?

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Estimated study tim...

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... on this learning outcome.