Personal pensions become more flexible

People with private pension savings will soon have more to think about

The government has announced a number of important changes to the rules for converting pension pots into income.

The main point is that it will end the effective compulsion to buy an annuity by age 75.

From 6 April 2011, there will instead be new rules for the existing pension drawdown arrangement, which will give investors more flexibility and control over their pension options when they retire.

The new rules include:

• Ending the effective compulsion to buy an annuity by age 75

• More flexibility to defer taking a pension and tax free cash payments past age 75

• Capped drawdown - an option to draw an income for life, with an annual limit, without having to purchase an annuity

• Flexible drawdown - those with secure incomes over £20,000 per year will have no limits on the income they can take from their drawdown

• Increase in the tax which is paid on lump sum death benefits from drawdown.

The basics

An annuity converts a pension fund into a guaranteed income for life, whereas with a drawdown arrangement, income payments are taken direct from the pension fund which remains invested in the stock market.

With an annuity, you can never run out of income, but with drawdown, you may erode your pension capital and eventually end up with less income.

When you (and your partner) die, income payments from an annuity stop.

But with drawdown when you die, any remaining lump sum can be paid to your beneficiaries.

Beyond 75

The government has ended the effective obligation to purchase an annuity at age 75.

Those with money purchase pension funds who have yet to take benefits will now be able to continue investing, leaving their fund untouched, and defer indefinitely a decision to buy an annuity or go into drawdown.

This means that any pension fund at age 75 can now remain invested until a decision is taken what to do.

This also means that after 2011, individuals will be able to take a pension commencement lump sum after their 75th birthday.

Capped drawdown

This will be the default option for drawdown.

Drawdown is riskier than an annuity, warns Billy Burrows

The maximum amount of income that can be drawn will be 100% of a comparable annuity, based on tables produced by the Government Actuary's Department (GAD).

This limit will be reviewed every three years until age 75 and every year thereafter.

Those who are currently invested in an alternatively secured pension (ASP), the current drawdown option for those over age 75, will automatically be converted into capped drawdown after April 2011.

Any remaining lump sum at death will be subject to 55% tax, instead of the current 82% rate.

Flexible drawdown

This is an option that will give those with very large funds more flexibility than everyone else.

Those over the age of 55 who can show that they have secured income in excess of £20,000 per annum, will be able to drawdown an unlimited amount from their pension funds each year, but this will be treated as income for tax purposes.

The income included for satisfying the new minimum income requirement (MIR) includes the basic state pension, additional state pension, level annuity income and scheme pensions.

The lump sum required to purchase an annuity which will satisfy the MIR, assuming the full state pension is payable, will be about £200,000.

This means that this option is only available to a small number of wealthy individuals.

Tax charges on death

So far, the news has been good, but now for the bad news.

At present, the tax on lump sum death payouts from drawdown funds, where the investor is under the age of 75, is 35% but is set to increase to 55%.

Those currently over the age of 75 and investing in an ASP will benefit, because they will see a reduction from the current 82% tax rate to 55% on lump sum payouts paid to non-dependant family members.

There will no tax on sums left to charity.

The current rules continue whereby there is no tax at all on pension funds where death occurs before age 75 and no benefits have been taken.

After 75, the 55% tax rate will apply.

Finally, it is confirmed that in normal circumstances, there will be no inheritance tax on lump sums left over after death.

Conclusion

These new rules, with the exception of the increased tax on death payouts, will benefit those who do not want to buy an annuity by age 75 or who want more flexibility and control over their pension.

However, the majority of people will probably still purchase an annuity in retirement, because it is the best way of securing a guaranteed income in retirement.

Drawdown is only suitable for those with above-average pension pots, because there is more risk and complexity.

The average size of personal pension funds at retirement in the UK is about £30,000, whereas a pot of more than £100,000 is the realistic minimum required for drawdown, though in the right circumstances it may be appropriate for those with smaller pots.

Investing in drawdown is more risky than buying an annuity, because drawdown pension pots are invested in the stock market.

This means that if investment returns are lower than expected, the value of the pension fund will be eroded.

Also, annuity rates may be even lower in the future, which would be bad news for anybody wanting to move from drawdown to annuity as they get much older.

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