By: JOHN WESTWOOD
Managing Director, Blacktower Financial Management Group
financial@portugalresident.com
WHEN IT comes to taking income from a pension plan at retirement, most people’s default option is to buy an annuity. The main advantage of an annuity is that it will not run out until you die. The principal drawback is that annuities are not flexible, so you cannot vary the income from them year by year to meet your changing needs. Fortunately, there is now a growing range of new alternatives when it comes to your retirement options.
The main alternative to annuities for people younger than 75-years-old is a pension fund withdrawal, which involves drawing income from your pension fund investments. The maximum permitted income initially is about 120 per cent of what an annuity could provide and the minimum is nil.
This structure of income drawdown offers considerable flexibility and means that if you die before the age of 75, the value of your pension fund (less a flat 35 per cent tax charge) can normally pass to your chosen dependants as a lump sum, free of inheritance tax (IHT).
However, the fact that your pension funds remain invested means that there are risks. If market conditions are poor, your income could fall and perhaps never recover. This has been the fate of some of the first investors to opt for income withdrawal when it became available in 1995.
With hindsight, many of them would have been better off with the guaranteed income provided by an annuity.
The obvious solution would be to build some form of guarantee into the income withdrawal process. At the time of writing, three companies had developed drawdown plans that incorporate income guarantees. Two of these plans allow you to invest in a range of funds, without the risk of stock market fluctuations potentially forcing a reduction in your income. The third plan can give you a guaranteed income and a guaranteed lump sum after a fixed-term of five or more years (before the age of 75). That lump sum must be used to provide further retirement income.
Until last year, if you chose income drawdown, you had to buy an annuity by the time you reached age 75. This changed from April 2006, with the introduction of alternatively secured pensions (ASP). These allow a restricted form of income drawdown to continue after the age of 75 and the remaining fund can be passed on subject to IHT.
In the March Budget, the Chancellor confirmed that such transfers would also be subject to income tax charges of up to 70 per cent.
These tax charges make transferring the ASP fund very unattractive as a means of estate planning. However, ASP may still be preferable to an annuity in some circumstances, for example, if you need income flexibility, have a much younger spouse and/or wish to leave your pension fund to charity on death.
As with pension fund withdrawals, for ASPs your starting point is to take advice. If you want to build your pension into your estate planning after the age of 75, there are still opportunities to do so.
The future of UK State Pensions
If you want to know what pension the state will provide you with in the future, there are now some reasonable answers in the Pensions Bill 2006. Unfortunately, the Bill is light on some detail, such as start dates but the broad outline is clear:
Annual increases in the basic state pension will be greater. Currently 87.30 pounds sterling per week for a single person in 2007/08, it will rise in line with earnings rather than prices. The Bill does not say when this will happen, but previous consultation papers suggested that the improvement would begin between 2012 and 2015.
The number of years you need to pay NICs to qualify for the full basic state pension will be reduced. If you reach state pension age (SPA) after April 5, 2010, then you will only need a record of 30 years of national insurance contributions (and/or credits) to qualify for a full pension. Currently, the requirement is between 44 years (SPA 65) and 39 years (SPA 60).
The age at which you can draw state pensions will rise. The SPA will increase to 66 between April 2024 and April 2026. Another year will be added in 2034/36 and again in 2044/46, by which time SPA will be 68. It has already been announced that women’s SPA will gradually rise from 60 to 65 between 2010 and 2020.
The state second pension (S2P) will slowly move from earnings-related to flat rate. However, the structure of national insurance contributions will not change. The transition should be completed by around 2030, according to Department for Work and Pensions estimates. S2P will by then be providing a flat rate pension of around 3,400 pounds sterling per year in 2007/08 terms.
The improvements are welcome but gradual and will probably not make a great difference to your retirement income.
The major winners will be the low paid, who should gain more from the improvements to basic state pension than they lose from the move to a flat rate S2P. But higher earners are likely to be worse off, with lower S2P benefits more than cancelling the basic state pension changes.
State pension benefits have never been enough to provide a comfortable retirement, and, in that respect, nothing has changed. No wonder the government is working hard to encourage private provision alongside its other pension reforms.
Do you have a view on this story? Email: editor@portugalresident.com
