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4. Unsecured Income

How does it work?

Unsecured Income provides a means of taking benefits from pension funds without committing to the purchase of an annuity immediately.

Under this option you can choose to take up to 25% of your fund immediately as a tax-free cash lump sum (upto the lifetime allowance). This option must be taken at outset; otherwise it will be lost.

In general, instead of buying an annuity with the remainder of the fund, the money remains invested, where it may benefit from investment performance in a tax-efficient environment. You may in this way defer taking an annuity until such time as it is considered more appropriate, although at age 75 you must either move funds into alternatively secured income or use the remaining funds to purchase an annuity.

Withdrawals taken from your fund each year may vary up to a maximum limit set at the time the arrangement is started. The maximum limit is derived from tables published by Government Actuaries Department (GAD) and is based on the size of your fund, your age, sex and the current gilt yield. It is not compulsory to take income from the fund and therefore income can be stopped in future if your circumstances so dictate.

Income levels are reviewed every five years and an appropriate adjustment to the level of income you receive may subsequently be necessary, where the level of income initially selected is above the maximum

Short-Term Annuities

Instead of drawing income straight from the fund, it is possible to purchase a series of short-term annuities.

This will give you peace of mind in relation to the income that will be received for up to five years whilst at the same time giving the flexibility to alter your requirements in future. The annuity payments must be paid at least annually and the maximum term that can be selected is for five years. The maximum income that can be taken is determined by rates produced by the Government Actuaries Department and will be the same as that applicable to income withdrawals. It is not possible to incorporate annuity protection or any form of guarantee into these short-term annuities. These short-term annuities can continue to be purchased up to age 75 when either an annuity must be purchased or when alternatively secured pension must be selected.

Investment Strategy & Management

The value of the fund, the level of income you withdraw each year and the final pension you purchase will all be dependent upon the careful management of the funds remaining invested. It is therefore essential that an investment strategy be adopted when starting this type of plan.

Every client’s circumstances and requirements are different, therefore there is no “perfect fund” and it is highly unlikely that one fund could meet all needs. However, in most cases a fund selection can be loosely based around basic needs of investing for the short, medium and long term. Basic portfolio planning should therefore look to:

  • Secure current income withdrawals (invest in assets that are reasonably liquid, aimed at consistency rather than high capital growth in the short term).
  • Maintain income requirements (invest to provide a good basis for capital growth within a controlled risk environment over the medium term).
  • Provide growth for the remainder (invest in areas which could experience greater fluctuations, but could be expected to provide a higher level of performance over the longer term).

The level of income you choose to take will have implications for the performance of your invested fund, and will influence future possible levels of annuity you can buy.

Whilst in the short-term drawing the maximum possible income from the plan may be very attractive, this may have repercussions in the medium to long term, as income from the plan is ultimately dependent on investment returns. For this reason, it is important that income requirements are balanced with a suitable investment strategy, which must be kept under regular review.

Critical Yield

This calculation aims to show, in percentage terms, the investment returns required per year from a pension fund withdrawal arrangement to “match” the income that could be paid by a conventional annuity. This is quoted as a “Type A yield.” A second figure “Type B” is also often quoted. This will have more relevance to your specific circumstances as it equates to the yield required to match your selected level of income. The figures take account of plan charges and mortality costs (see below) and assume that during the period of taking withdrawals, the underlying annuity interest rate and mortality basis will not change.

Mortality

The concept of mortality drag and mortality gain and how it impacts on the advice given should be understood.

As the risk of mortality increases with age, this is reflected generally in higher annuity rates. Therefore it could be argued the longer a client postpones the decision to buy an annuity the greater the likelihood of a higher annuity income. However, this decision is not risk free - especially when income withdrawals are being taken from the plan.

With a conventional annuity there is an element of "cross subsidy" between those who die during the early years of annuity payments and those whose payments last longer than expected. This is reflected in the level of annuity payments and is sometimes referred to as MORTALITY GAIN.

If a client takes income withdrawals equal to the conventional annuity he or she could have purchased, there is no cross subsidy. This may have a cumulative effect over a period of time, which means investment returns have to be high enough to compensate for the absence of a subsidy from those who die early. This is usually referred to as MORTALITY DRAG.

Looking at it from a different perspective, many annuities tend not to have a death benefit whereas with Unsecured Income there is a return of the balance of the fund. It could be argued that there is a cost for this (in the same way that adding inflation proofing or spouses' benefits increases the cost of annuities) and this cost could also be viewed as the mortality drag. This issue will diminish in future as more annuities start to incorporate some form of death benefit, however it will be sometime before the effect reduces significantly.

What happens if you die?

There are several options available to your nominated survivor if you die while taking income withdrawals:

  • Receive the balance of the invested fund as a cash lump sum, subject to a tax charge of 35%.
  • Purchase an annuity.
  • Continue taking income withdrawals or purchasing short term annuities until either he/she reaches age 75 or you would have reached 75, whichever is the earlier and then purchase an annuity with the remaining fund, or continue withdrawals via alternatively secured pension.
  • (If your spouse is under 60 when you die) leave the value of the fund in the plan and defer purchasing an annuity up until his/her 60th birthday, however the fund would be forfeited if your spouse then died prior to age 60. It is not possible to take income withdrawals once this option has been selected. Taxation Issues
  • Income withdrawals are subject to income tax.
  • If, on death, the remaining fund is paid as a lump sum, a tax charge of 35% is applied.
  • Generally, any lump sum will be paid free of inheritance tax but, in certain situations, the HM Revenue & Customs may apply such a tax. The Capital Taxes Office (CTO) has confirmed that there are two main instances where IHT may apply. Firstly, where the only possible beneficiaries of the Death Benefits are the policyholder’s estate or legal personal representative. Secondly, where the CTO find evidence that the pension arrangement has not been used primarily for the purpose of pension provision. Typically, this is where the policyholder has acted knowing he or she is suffering terminal ill health and this results in increasing someone else’s estate at the expense of pension provision.
  • When tax-free cash is taken at outset and not utilised, it may be included in the value of your estate and therefore increase any potential inheritance tax charge.

Advantages

  • You are able to take the full tax-free lump sum entitlement at outset.
  • The pension funds from which you take income withdrawals remain invested, therefore you retain control of your investment portfolio and potentially benefit from the growth provided by the investments selected.
  • It gives the flexibility to either phase and/or defer annuity purchase.
  • Income may be varied, between set limits, to suit your personal circumstances.
  • The facility to vary income levels may provide scope to mitigate your personal liability to income tax in certain years.
  • The value of death benefits may be more attractive than annuity purchase.

Disadvantages

  • Future investment returns are not guaranteed and the value of the pension fund may fall. This may therefore result in a lower total income than if an annuity was purchased at outset.
  • Annuity rates may be lower in the future. As a result, the eventual annuity may be lower than the annuity that would have been available at outset.
  • High withdrawals of income may not be sustainable during the income withdrawal period and may also reduce the amount of any potential annuity.
  • The higher the level of income withdrawal chosen, the less that may be available to provide for dependants, particularly when the original fund is small and/or investment returns are poor.
  • Increased flexibility brings increased administration costs. Charges are likely to be higher than those relating to the purchase of a conventional annuity and may increase in the future.
  • It is possible that the level of income selected at outset may need to be decreased or increased to comply with new limits arising from a quinquennial review.
  • The value of death benefits may not be as attractive as phased retirement or combination of phased retirement and income withdrawal or short term annuity options.

For whom might Unsecured Income be suitable?

  • Those who need the maximum tax free cash but do not require all the income that an annuity would provide.
  • Those who are not entirely dependent on the income from the pension plan and can therefore afford to see fluctuations in its level.
  • Those who understand the degree of risk involved and can afford to take such risks because, for example, they have substantial investments outside the pension plan.
  • Those who are not married but have dependants, given that the death benefits compare favourably to annuity purchase, where survivor pensions for anyone other than a spouse may be difficult to arrange.
  • Those in ill health, although careful comparison should be made with any available impaired life annuity.
  • Those who do not wish to be “locked” into buying additional benefits that are not required. For example, some pension schemes require a widow(er) pension to be purchased, which will be of no benefit if there is no spouse, or the spouse is in poor health.

Other Points to Consider

  • Those with larger funds, requiring lower incomes, will derive most benefit; fund size being important to cope with the extra administration costs involved and income levels to reduce the possibility of poor investment performance eroding fund value.
  • Considerable caution is therefore needed if you need to take the maximum income. An annuity providing a similar level of income, guaranteed for life, is probably better suited to risk adverse clients than the riskier option of unsecured income.

Whether unsecured Income is the correct strategy for you will depend both upon your willingness to accept risk, including the need to attain investment performance above a “critical” level.

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