Income Drawdown and Simplification
Following two prolonged consultation periods and an assessment by the National Audit Office as to the validity of some of the Treasury's assumptions, Pensions Simplification finally arrived in the form of almost one third of The Finance Act 2004 that 'weighs in' at no less than 656 pages!
For many Clients with Small Self-Administered Schemes (SSAs) and Self-Invested Personal Pensions (SIPP), one of the points of immediate interest (and in some cases celebration!) is that there will be no compulsion to purchase an insured annuity by age 75 at the latest. However, the change will only affect those who attain age 75 after 6 April 2006 [A-Day]. A brief review may therefore be helpful as SSAS and SIPP are already extensively used for the payment of pension under the current Income Drawdown provisions.
What is Income Drawdown?
Put simply - the ability to leave the pension fund invested whilst drawing an income and deferring the purchase of an annuity. However, the maximum income that can be taken still has to be broadly in line with an annuity that could be secured from the available fund.
The ability to defer the purchase of an annuity was originally introduced in limited form for SSAS from 5 August 1994 but it was only following The Finance Act 1995 that truly flexible Income Drawdown was introduced for SIPP from 1 May 1995. This was eventually extended to SSAS from 30 June 1999.
There has been increasing pressure on the Government to abolish the enforced purchase of an annuity at age 75 almost since the original introduction of Income Drawdown. This is essentially because many perceive the main drawback with an annuity is that none of the capital can be returned on death. Equally, falling interest rates and Gilt yields, coupled with low inflation and improving mortality have generally given rise to the perception that annuities are poor value for money. However, taking account of what appears to be an ongoing trend in increased longevity, it must always be borne in mind that current terms could prove to be 'cheap' by comparison with annuities in the future. Also, annuities are still the only way to guarantee a lifetime income.
Given the length of time that Income Drawdown has already existed, many Clients have got used to controlling their own destiny and will be relieved to hear that the general principle will be maintained after A-Day.
Benefits up to age 75
Income Drawdown [to be formally known as Unsecured Pension after A-Day] will still only be available between the ages of 50 [55 from 6 April 2010] and 75, although ill-health early retirement is allowed at any age.
The maximum income will be 120% of a level, non-guaranteed annuity for a non-smoker of the same age and sex. The annuity will effectively be the most competitive in the market, as it will be calculated from the Comparative Annuity Tables produced by the Financial Services Authority.
At first sight, this may appear more generous than the current basis of calculating maximum income. However, the Government Actuary's Department [GAD] factors that have to be used at the moment do not take account of up to date mortality assumptions and are approximately 15% higher than current market annuity rates. The effect of the 20% uplift will therefore do little more than maintain the current rates and a large increase in income should not therefore be expected after A-Day!
Under current rules, an income of at least 35% of the maximum available has to be withdrawn each year. However, after A-Day, there will be no requirement to take an income. This will undoubtedly prove popular with those Clients who wish to take their Tax-Free Cash at the earliest possible date but who may then wish to defer income to avoid exacerbating their tax position.
Also, it has now been confirmed for SSAS Members that benefits can be taken whilst remaining in Service (this has always been the case for SIPP). This easement will assist those who wish to take a reduced role in their employment and supplement any reduction in income by taking pension.
The formal Review Dates will be increased from three to five years but can still be based on the value of the fund on a selected day within 60 days prior to the Review Date. However, we will continue to recommend that ongoing reviews be conducted at least annually to ensure that the position does not get out of hand. This is particularly important where maximum income is being taken.
Benefits payable on the death of a Member during Income Drawdown are unchanged. The surviving spouse has the choice of continuing Income Drawdown, buying an annuity or taking the fund less the 35% tax charge.
Benefits after age 75
Now the good news! Following pressure from a 'religious group' that had principled objections to the pooling of mortality risk involved in annuity purchase, the Government [rather surprisingly] has relented to some extent in its requirement that pensions be secured by annuity purchase no later than age 75. Alternatively Secured Pension (ASP) will be available as an alternative to the enforced purchase of an annuity at age 75 and the pension can be 'zero', as there will still be no requirement to take an income each year!
Now the bad news! ASP is a restricted form of Income Drawdown, as the maximum income will be only 70% of a 'Relevant Annuity' that must always be calculated based on age 75, rather than on the individual's actual age attained.
Those who have taken the maximum income up to age 75 will feel the worst effects of this restriction. On the change to ASP, their income will have to be immediately reduced by just over 40% when account is taken of both the loss of the 20% uplift and the imposition of the 30% reduction!
The basis on which ASP is calculated and the requirement for formal annual reviews is an attempt to ensure that the fund is not depleted too quickly. The Government obviously wishes to try and ensure that no one who has enjoyed an income up to age 75 can come 'cap in hand' for State Benefits if they run out of money!
On the death of a Member taking ASP, the surviving spouse has the choice of continuing ASP, or buying an annuity. However, as the Treasury and the Inland Revenue have maintained their collective stance against 'heritable wealth' being generated from a SSAS or SIPP, taking the fund as a capital payment is not allowed, even less the 35% tax charge.
Taking account of this stance, it is rather surprising that, if there is no surviving spouse, the fund may then be reallocated to another Member of the same SSAS. A nomination of the potential death benefit must have been made prior to the Member's death and a Charity can be nominated if there are no other potential recipients.
Even though the ASP provisions fall short of allowing capital to be returned directly to beneficiaries, this is still a significant change that could allow tax-planning opportunities for those who can accept a restriction in income to allow funds to pass within a SSA to the next generation.
Conclusion
Taking account of the changes, it is now more important than ever to take advice on the best way of both saving for retirement in the future and also the basis on which funds are applied [and invested] to produce income in retirement - as this could last a very long time if improvements in mortality continue and an annuity is not purchased at age 75!
Barnett Waddingham LLP, October 2004.