Pensioners are being trapped into low levels of pension income with persistently poor annuity rates. Here's one alternative to help you get more out of your pension fund.
Annuities have long been contentious, not least because poor annuity rates are locking pensioners into ever lower levels of income. But, despite strong criticism, annuities are by far the most widely used approach when it comes to taking pension benefits.
Annuities certainly have their advantages. They're relatively easy to understand and provide a secure, constant or increasing level of income for the rest of your life. But, looking at it another way, this can make annuities inflexible since, once you've chosen one, the income levels can't be adapted to suit your changing circumstances.
And, more worryingly, annuity rates are unlikely to improve in the short term due to increased life expectancy combined with an expectation that interest rates will remain low for the foreseeable future. So, if you've already built up a pension fund, are there any alternatives?
Unsecured Pension
It's a complex business, so I'll just focus on one of your other options. Income drawdown, or what is now called an Unsecured Pension (USP). USP essentially allows anyone up to the age of 75 to draw an income from your pension fund while the rest remains invested. (Drawdown after age 75 is now termed Alternatively Secured Pension -- ASP, although these are sadly much more restrictive.)
USP has a lot going for it. Because your pension fund remains invested there is continued potential for capital growth by keeping it in the stock market longer. And it remains within the tax-efficient environment that all pension funds enjoy. You can decide how your particular plan is invested instead of sacrificing it to an annuity company, enabling you to retain greater control. And the income you draw can be varied, within the specified limits, to suit your needs making it a far more flexible plan.
USP also appeals to many investors because of the more flexible options on death. Your chosen beneficiary can benefit from continued USP (ASP if they're over 75) or they can use the remaining fund to purchase an annuity. Alternatively the fund can be converted to cash and paid out with a 35% tax deduction. Many investors have been put off annuities because benefits are usually lost on death but USP appears to have served up a solution.
These are all valid reasons for choosing USP, but perhaps the greatest benefit is the prospect of drawing a greater income than a conventional annuity can provide. Based on current limits the maximum annual income a 60-year-old male with a £75,000 pension fund can take from a USP plan is £5,850. But if he used his pension fund to purchase an annuity instead, even choosing the most competitive annuity provider available, he would still end up with around £1,000 less.
Five things to consider
Does USP sound good to you? Well it can be, but not surprisingly it comes with several crucial caveats which I'll outline now.
- Consensus suggests USP is better-suited to HNW (high net worth) individuals who fall into the 'sophisticated investor' category. Typically you'll need to accumulate a pension fund of £100,000 plus to make USP viable. Unfortunately, this precludes most of us since the average pension pot is less than a third of that. But USP is becoming more popular with the number of active plans rising fast.
- USP is a much riskier strategy than simply purchasing an annuity because your fund remains invested and therefore exposed to ongoing investment risk. If the assets you select suffer poor investment returns, your USP fund may not be able to fully support your income withdrawals, particularly if they're high. Poor performance may force you to reduce the level of income you draw from the plan.
- It's important your fund achieves a critical yield, where investment growth allows the income drawn from USP to at least match the income that would have been produced by a conventional annuity if you had chosen that option at the outset. Because of this, USP plans require ongoing reviews to ensure the value of your fund hasn't eroded.
- The charges on USP are generally higher when compared with conventional annuities and therefore the investment return from your fund will need to compensate for that.
- With this type of arrangement you're still entitled to the same 25% tax-free cash lump sum that you're eligible for when purchasing an annuity. But you must elect to take this when you move into USP. There's no option to take tax-free cash at a later stage.
Income Limits
There are limits set on the amount of income you can take from USP each year to ensure that your pension pot is not depleted by making excessively high withdrawals.
The limits are based on USP rates calculated by the Government Actuary's Department (GAD). The GAD's tables show the USP rates, which are based on your age, gender and the current yield produced by gilts. This figure is then used to work out the maximum income you can take. For every £1,000 of your USP fund, you can take up to 120% of the GAD basis amount.
The table below gives you an idea of the maximum income you can draw if you've accumulated a pension fund of £100,000 and wish to take full tax-free cash at 25%:
Gender | Age | Funds available for income withdrawal | GAD factor (basis amount per £1,000) | Max annual income | Max monthly income |
|---|---|---|---|---|---|
Male | 60 | £75,000 | £65 | £5,850 | £488 |
Male | 65 | £75,000 | £73 | £6,570 | £548 |
Male | 70 | £75,000 | £85 | £7,650 | £638 |
Female | 60 | £75,000 | £62 | £5,580 | £465 |
Female | 65 | £75,000 | £68 | £6,120 | £510 |
Female | 70 | £75,000 | £77 | £6,930 | £578 |
The GAD factor increases with age because your life expectancy is lower the older you get. The GAD factors are also lower for women as they are expected to live longer than men. (This is the same as with annuities.) As you can see from the table, a 60-year-old man with a USP fund of £75,000 can take a maximum yearly income of £5,850. But there's no requirement to take an income at all. If you wish, you can opt to take a nil income and, of course, vary the amount you take between that and the maximum.
USP certainly has the potential to reward you with an enhanced level of pension income. If you've built up a sufficiently large pension fund and you want to take greater control of your retirement planning, then USP could be for you. But the greater risks involved do mean it won't suit everybody. In fact, I reckon most people are better off with the safer annuities.
Read more: Poorer Postcodes To Get Better Pensions | The Four-Step Guide To A Comfortable Retirement.