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If you have a range of income sources at retirement or are still working, you may be prepared to accept a higher risk with the possibility for greater income in the future. By phasing your retirement or selecting income drawdown your pension remains invested benefiting from growth and higher annuity rates with age.
  Introduction   Money purchase schemes   phased retirement
  Pension drawdown   Tax free lump sum   

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Since A-Day on 6 April 2006 a member can select a compulsory purchase annuity or pension annuity before the scheme members age of 75 or an alternatively secured income (ASI) to draw an income. Up to age 75 the member can take a flexible income to phase in retirement. This can be achieved from pension withdrawal in the form of pension drawdown.

The income from drawdown can be any amount from £0 per annum up to a maximum of 120% of the highest annuity payable for a person of their age. Both defined income such as from a final salary pension and flexible income from a money purchase scheme will be able to take a tax free lump sum. For phased retirement the lump sum will be realised over time when part of the pension fund is used for a compulsory purchase annuity. In contrast pension drawdown will realise all the lump sum initially with a variable income paid thereafter.

Money purchase schemes
Where a scheme member can contribute to a pension fund and the benefits at retirement age are uncertain, as they are dependent on the size of the funds under management, but the contributions are known then this is referred to as a defined contribution scheme. A defined contribution can be made to a money purchase scheme and could be operated by an employer as an occupational money purchase scheme, a group personal pension or simply established by a person as an individual policy such as a stakeholder pension.

Since Pension Simplification from 6 April 2006 the amount of retirement benefits from a money purchase scheme is limited to the Lifetime Allowance which is a total fund of £1.5 million in 2006/07. In terms of contributions the member is limited to the Annual Allowance which is £245,000 in the 2009/10 tax year.

However, tax relief on the contributions is limited to the higher of 100% of relevant earnings or where tax relief is given at source, limited to £3,600. There is now no restriction to the earnings cap or to the 15% contribution of pensionable earnings as existed before A-Day. Furthermore the limit for contributions such as 17.5% to 40.0% for personal pensions and stakeholder pensions or 15.0% of pensionable earnings for members of an occupational money purchase scheme have been replaced to allow individuals to make contributions subject to the annual allowance and this gives the individual the opportunity to contribute considerably more to their retirement planning.

For all money purchase schemes the retirement benefits can be taken between 50 to 75 years of age. At age 75 the member can purchase an annuity after taking a tax free lump sum of 25% or switch to an Alternatively Secured Pension (ASP) and draw an income.

The opportunity to defer purchasing an annuity can greatly enhance the possible income from the pension fund. However, although the schemes are flexible there is an associated risk that the value of the underlying assets can go down as well as up. Nevertheless for those individuals prepared to take a greater risk, pension withdrawals can give the members an income in the short term with the prospect of investment growth in the future. Before making a decision regarding the Alternatively Secured Pension, learn more about annuities, compare annuity rates, and secure a personalised annuity quote offering guaranteed rates.

Pension drawdown

The Financial Services Authority (FSA) Handbook of Rules and Guidance, define a pension fund withdrawal (PFW) and states that in relation to a decision of a customer, in respect of a personal pension scheme, to defer the purchase of an annuity and to take either:

Income withdrawals within the meaning of section 630 of the Income and Corporation Taxes Act 1988 (ICTA) as amended by section 58 and schedule II of the Finance Act 1995, and any provisions amending or replacing it;
Or payments made under interim arrangements in accordance with section 28A of the Pension Schemes Act 1993 (PSA 93), as inserted by section 143 of the Pensions Act 1995, and any provisions amending or replacing it;
And in respect of an election to make pension fund withdrawals, a reference in the rules to a consumer, an investor or a policyholder includes, after the persons death, his surviving spouse and/or anyone who is, at that time, his dependent.

The PFW is better known as pension drawdown or phased retirement and where the pension income must be supported by the critical yield calculation. Provisions introduced in the Finance Act 1995 allowed members of personal pensions to select pension fund withdrawals known as pension drawdown rather than acquiring a compulsory purchase annuity with the pension remaining invested in an insurance company fund.

Pension drawdown allows the member to have more control over their pension, but must still buy pension annuities at the age of 75. When the member takes drawdown, commutation to a tax free lump sum of 25.0% is possible and the balance of the fund must be used for drawdown. Pension simplification from 6 April 2006 replaces the Government Actuary's Department (GAD) income tables allowing a minimum income withdrawal of £0 and a maximum of 120% of a single life annuity and this income amount is to be reviewed every 5 years. Previous to A-Day the withdrawal levels were subject to minima (being 35.0% of the maxima) and maxima based on the GAD income tables on long-dated gilt yields that were reviewed every three years.

However, it is always possible to take the tax free lump sum and buy a purchase life annuity to provide guaranteed income, that represents in part a return of capital (usually being about 2/3rds of the income) and the balance of interest taxed at the savings rate of only 20%. The advantages of annuity taxation therefore favour a purchase life annuity rather than pension annuity.

Phased retirement
Rather than opting for pension drawdown, phased retirement, also known as staggered vesting, allows the member to defer drawing all of their pension benefits and spreading them over time, up to the age of 75 at which time the balance of the fund must be taken as a compulsory purchase annuity. Designed to give the member more control over income at retirement age, phased retirement allows segments of the pension fund to be drawn when required.

A personal pension plan uses the practice of segmentation and will consist of up to 1,000 identical but separate segments. Each time the member draws on a segment, a tax free lump sum of 25.0% can be taken and the balance used to purchase a compulsory purchase annuity. The remaining the fund value will remain invested with the provider. The main advantage is that:

It allows flexible pension planning;
Allows the phasing in of pension income with part time work;
Lets the individual take their retirement benefits as a pension annuity later when annuity rates could possibly be higher as the member becomes older;
Offers the potential for investment growth in the remaining fund.

The disadvantage is that:

The tax free lump sum will be phased over time with each segment withdrawn;
Inflation, Interest rates and hence annuity rates could fall further;
Investment returns could be poor resulting in a smaller fund value.

Tax free lump sum
A tax free lump sum commuted from a pension fund can be paid to the scheme member at retirement. For a defined contribution scheme such as personal or stakeholder pension and occupational money purchase scheme the tax free lump sum is 25.0% of the fund value.

Since A-Day, the Pension Simplification rules introduced from 6 April 2006 allow a tax free lump sum of 25% to be taken from all pension arrangements. This includes an occupational pension scheme such as a defined benefit final salary pension, money purchase scheme, Additional Voluntary Contribution (AVC) or FSAVC, retirement annuity policy (RAP) and contracted out protected rights such as SERPS and S2P.

Previous to A-Day, for a final salary pension or money purchase scheme, this lump sum would have been derived from a formula based on the members final salary and number of years in employment. This would be either two-and-a-half times the pension income at retirement age or, if greater, 3/80ths for each year of service up to retirement times the final salary for the year up to a maximum of one-and-a-half times final salary.

Since A-Day any occupational pension scheme members that have rights to take more than 25% as a tax free lump sum will automatically retain these rights within the plan. For a contracted in money purchase scheme (CIMP) where the contributions are small, say 2.0% to 3.0% of net relevant earnings, at retirement age up to 100% of the fund value could be taken as a tax free lump sum.

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