Pensions

Annuities, income drawdown and phased retirement explained by Pam Atherton

When you come to retire, you have a number of options as to how you can take your pension.

If you have been a member of a final salary scheme, you do not normally need to do anything because your pension will be paid from the scheme assets.

But if you are a member of an occupational money purchase scheme, the trustees will buy an annuity on your behalf, so it may be a good idea to alert the trustees if you have a lifestyle or medical condition, such as smoking or obesity, which might reduce your life expectancy and thereby make you eligible for a higher annuity rate.

Annuities

If you have any type of personal pension, your fund at retirement can be taken as free cash up to 25%, with the balance used to purchase an annuity.

You can shop around for your annuity by using the 'open market option'. This allows you to scan the entire insurance market for the best annuity rates, for your particular circumstances.

Income drawdown

But it is possible to defer the annuity purchase until your 75th birthday, when annuity purchase is currently compulsory, by doing an income drawdown. This is the facility to take up to 25% of your fund as tax free cash, while keeping the remainder invested in the stock market until age 75.

In the interim, you are allowed to take an income from your fund within certain Income Revenue limits which must be reviewed every three years. The maximum is approximately the same level as an annuity paid to a single person, while the minimum is 35% of the maximum.

Drawdown clearly carries several risks, such as your fund dropping in value and annuity rates falling, so it is normally only recommended to those with substantial pension funds or other assets to live off.

Death benefit rules

Many people like drawdown because of the death benefit rules, which allow your fund to pass to your dependents less 35% tax if you die before age 75 while doing draw down.

This can be particularly beneficial if you have a much younger spouse, you are in poor health or have a very large fund which you particularly wish to leave to your dependents.

If you have a younger spouse who is under 60 years old when you die, there is a special Inland Revenue dispensation whereby, providing your spouse leaves the drawdown plan intact after your death, he or she can purchase an annuity at age 60.

Alternatively, if your spouse is over 60 when you die, they can continue doing income drawdown until age 75, when an annuity must be bought. If your surviving spouse also dies while doing income drawdown, the remaining fund, less 35% tax, passes to his or her estate.

Phased retirement

Another way to defer annuity purchase is to do phased retirement. This allows you to encash a small amount of your fund each year until age 75.

Most personal pensions are divided into 1,000 segments for the purposes of phased retirement, so that you encash a small number of segments each year.

You then use 25% of these encashed segments to take tax free cash and the remainder of these segments to buy a mini annuity.

You can then repeat this exercise as often as you like until age 75, by which time you must purchase an annuity with the remainder of the fund.

By doing this, you can build up a growing stream of income as well as being able to take a small amount of tax free cash each year.

From 6 April 2006, income drawdown rules will change and you will be allowed to continue doing a restricted form of income drawdown after age 75, to be called an Alternatively Secured Pension.