Regulations introduced in the Finance Act 2004 effective from 6 April 2006 changed the amount that can be drawn from an income drawdown plan between the ages of 55 to 74, and introduced an alternatively secured pension from age 75. This means it is possible not to purchase a pension annuity until the member is older when annuity rates and the pension fund value could be higher.

Income drawdown is higher risk than a pension annuity and is referred to as an unsecured pension. There is no requirement to take an income, however the maximum income that can be drawn is 120% of a comparable annuity for a single person at a given age as determined by the Governments Actuaries Department (GAD) and results shown in the drawdown rates. An alternative route could be to use phased retirement where only part of their fund is used for a compulsory purchase annuity. Both pension drawdown and phased retirement will require a fairly large initial fund value in order to make it worthwhile, usually about £100,000 after tax free cash. Significant advantages of income drawdown are the ability to take the tax free lump sum of 25% while leaving the pension fund invested and improved death benefits for a spouse or beneficiaries. Income drawdown is more suitable to individuals that continue to have other income sources to rely on such as working part-time or income from other pensions, such as a final salary pension. As the pension fund remains invested typically in equity based investments, the individual must be prepared for some volatility in the fund in the future. There is also the potential for future growth in the fund and the tendency for annuity rates, and hence pension income, to increase with age.   • unsecured income • basis amount     • income withdrawals • reference dates     • tax free lump sum • gilt index yields     • age limits • GAD tables     • costs and risks • worked example     • mortality drag • drawdown rates     • death benefits • advantages     • alternatively secured pension • disadvantages     • drawdown suitability

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Unsecured income
Since the pension simplification changes from 6 April 2006, unsecured income is the current official term for Income Drawdown which is also know as "pension drawdown" or "pension fund withdrawal".

The term "unsecured income" refers to a pension arrangement whereby the underlying assets remain within investments that can go up and down in value and is therefore not secure as the level of payments cannot be guaranteed for life. A "secure income" refers to a pension arrangement whereby there is a guarantee or security of payment for life, such as a final salary pension scheme or pension annuity.

An unsecured pension fund is the fund of tax relieved pension savings which allows an individual the facility for income withdrawal. It is only possible to have an unsecured pension fund up to age 75. For those individuals that do not wish to purchase a pension annuity at age 75, an alternatively secured pension fund permits the extension for income withdrawal subject to greater restrictions.

This structure for income withdrawal was introduced in the Finance Act 2004 and implemented through The Registered Pensions Scheme (Relevant Annuities) Regulations 2006 effective from 6 April 2006. The regulations require that the "annual amount" of a "relevant annuity" is to be calculated using HM Revenue & Customs (HMRC) tables prepared by the Governments Actuaries Department (GAD).

Originally unsecured income was known as pension drawdown but in 1997 the Personal Investment Authority (PIA) changed its name to pension fund withdrawal. The concept was introduced by the Inland Revenue as an alternative a pension annuity. Pension fund withdrawal was originally introduced as part of the Pensions Act 1995 and integrated into the existing personal pension structure rather than create a new product.

Although it is possible for an individual to use pension fund withdrawal from an occupational pension scheme, called occupational drawdown, this is usually only considered if the tax free lump sum from the occupational scheme is greater than the 25% tax free cash from a personal pension. If it is less, an individual that wants to benefit from pension fund withdrawal will usually transfer to an income drawdown plan.


Age limits
An individual can enter into an income drawdown plan from the age of 50. Subsequent to Pension Simplification rules implemented from 6 April 2006 this minimum age is to rise to age 55 from 2010 as part of the Government policy to encourage greater participation in the labour market by older workers.

Previous to A-Day a pension annuity had to be purchased at the age 75. This requirement is no longer necessary, however the member would be required to transfer to an Alternatively Secured Pension (ASP) which offers income withdrawal similar to income drawdown but with more restrictions as implemented in regulations effective from 6 April 2007.


Tax free lump sum
For many pension scheme members the primary advantage of income drawdown is the opportunity to tax free lump sum sum of up to 25% from their pension fund value immediately without the need to purchase a pension annuity. If the member does not take the tax free lump sum at the outset, the right to take a cash lump sum is lost thereafter.

This means a cash lump sum is available from the age of 50 (age 55 from 2010) and post A-Day it is possible to leave the remaining fund to benefit from investment performance in a tax-efficient environment without the requirement to drawdown an income. Before 6 April 2006, the member would have been required to take an minimum income of 35% of a single life annuity as determined by GAD.


Income withdrawals
With the introduction of pension simplification from 6 April 2006 a member of an income drawdown plan can draw a maximum income of 120% based on the GAD tables and where the minimum represents 0% of this maximum applicable up to the age of 75. Previous to A-Day the withdrawal amounts from income drawdown was a maximum income of 100% of a single life annuity and the minimum was 35% of the maximum.

For members aged 75 years that wish to continue with a similar income withdrawal arrangement, they must transfer to an alternatively secured pension (ASP) that applies more restrictions to income. Regulations applicable from 6 April 2007 apply a minimum income requirement of 65% and a maximum of 90% of GAD tables for a comparable annuity rate at age 75 years. Originally from 6 April 2006 the income levels were set at a minimum income requirement of 0% and a maximum of 70% of GAD tables for a comparable annuity rate at age 75 years but were changed to deter those with no religious objection to purchasing a pension annuity from continuing with an ASP arrangement.

The GAD tables are a measure of the annual amount of lifetime annuity income an unsecured pension fund such as income drawdown could generate for a member being males, females or dependants, at the point of calculation and also apply to any contracted-out protected rights portion of the pension fund. These tables are based on a standard annuity, single life, level with no guarantee period and contain rates covering an age range from 0 to 75 years old. This range is required as a child dependant could have a dependant's unsecured pension fund from birth and for individuals 75 years and older, an ASP fund will use the GAD tables for a 75 year old.

Every five years the income levels of the tables are reviewed by GAD and adjustments made based on long-dated gilt yields which could mean the maximum income that can be withdrawn will change. This is because the individual is older and receive a higher income or if the gilt yields have fallen, a lower income.


Mortality drag
Insurance companies offering annuities use actuarial data to anticipate broadly how long a group of people will live on average. This means they are better placed to manage the risk of a group of individual funds running out during their lifetime than an individual could manage themselves.

A benefit of this group "pooling" is that some members in the group will die earlier than expected and the insurance company can therefore continue to pay those that live longer, resulting in a mortality cross-subsidy. Unsecured income from an income drawdown plan does not participate in this mortality cross-subsidy as income is drawn directly from the individual investment.

To compensate for losing the cross-subsidy if a member delays buying a pension annuity, the underlying investments within an income drawdown plan need to grow at an extra amount and mortality drag describes this effect. This Mortality drag is also referred to as the gap between the available annuity rate at a given age and the conventional interest rate.

Mortality drag increases with the member's age at annuity purchase as the benefits of mortality cross-subsidy increase. It is estimated that an additional investment return required above gilt yields for a male would be 1% per annum at aged 60, 2% per annum at age 70 and 3% per annum at the age of 75. If the investment return is less than these levels, it would not be worthwhile delaying an annuity purchase.


Costs and risks
Income drawdown plans represent a higher risk to the individual than a secured income arrangement such as a pension annuity as the underlying assets of the fund are usually invested in the stock market. To ensure the pension fund does not run out of money, the member will require investment advice and regular reviews.

Over the life of the an income drawdown arrangement these costs have been estimated at approximately 5% of the initial fund value although large funds will have a lower percentage as there are more assets to off-set fixed costs.

The cost of managing a pension annuity contract is much lower as the resources of a group of individuals are pooled and there is no need to review on an individual basis. The insurance company must ensure there are sufficient reserves to meet the liabilities, however, this cost is spread across the entire group of individuals. In addition annuities require a simpler advice process than income drawdown with a one-off administration charge to establish the annuity contract of about 1% to 1.5% of the initial fund value.

Due to the higher costs associated with income drawdown, fund sizes should be at least £100,000 after taking a tax free lump sum. As the growth of the pension fund depends on investment performance, it is important to have alternative retirement income or savings in addition to an income drawdown plan in the event of poor investment performance.


Death benefits
A significant reason for considering income drawdown rather than secured income such as an annuity are the associated death benefits. If the member dies while invested through an income drawdown plan, the remaining vested fund will pass to a spouse or estate. A spouse has a number of options as follows:

If the spouse continues within income drawdown they can do so until they are age 75 or until the time their deceased spouse would have reached 75, whichever is the sooner. Any income received from this arrangement would be subject to income tax. By taking the fund as a lump sum the spouse must pay a 35% tax charge. In general the residual fund is paid free from Inheritance Tax (IHT) although HMRC may apply this tax.


Alternatively secured pensions
At the age of 75, an individual with an income drawdown plan must either purchase a pension annuity or transfer to an alternatively secured pension (ASP). This would allow the member withdrawal of income, similar to income drawdown.

Alternatively secured pensions have been introduced in particular to assist those individuals with religious beliefs that prevent them from purchasing an annuity on ethical grounds.

From 6 April 2007 new rules introduced for ASPs apply a minimum income requirement of 65% and a maximum of 90% of GAD annuity tables. Any payments that fail to comply with these limits will incur a 40% tax charge on the difference between the minimum income limit and the amount of income withdrawal paid during that year.

The reason for these changes were due to the Government's awareness of ASPs being used by those intending to avoid being forced to purchase an annuity at age 75. Since being introduced from A-Day with a minimum of 0% and a low maximum withdrawal of 70% of the Government Actuaries Department annuity tables, it has not deterred those with no religious objection to purchasing a pension annuity from using an ASP for capital accumulation or succession purposes.

Where funds remain on the death of the member, in contrast to income drawdown, an ASP must first provide for any financial dependants. Thereafter any surplus can be passed to a charity as an authorised payment and free from any tax charge. Any surplus where there are no nominated charities or financial dependants is an unauthorised payment and subject to a tax charge of up to 70% and becomes the top part of the member's estate for Inheritance Tax (IHT).

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