PensionsMay 29 2019

Income for life: How different pension schemes work in practice

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Income for life: How different pension schemes work in practice

When it comes to accessing pension benefits, there are now many options available, although not each of them will be a viable option for everyone. 

In some cases, it makes sense for an individual to mix and match benefit options to suit their needs as they go through the stages of retirement.

DB schemes

Defined benefit pension schemes get their name because the benefits are determined as they are accrued, rather than by the investment growth or even the contributions made. They generally take two forms: those that are determined by the final salary of the member (final salary pension schemes), and those that are determined by each year’s salary independently (career-average pension schemes). The result is similar in either case – a promise from the scheme to pay an income for life.

Most schemes will also offer a pension commencement lump sum that could be accrued in the plan separately, but over the years schemes have changed and now pay this by reducing the pension payable to the member. This is known as commutation, because you commute the pension using a factor to give a tax-free lump sum, the PCLS. 

The member therefore has the option to take a greater pension and lower PCLS or vice versa. There are limits on the amount of PCLS that can be taken, which is roughly three times the residual scheme pension payable after commutation.

The pension freedoms that came into force in 2015 do not apply to these types of schemes, so very little has changed in recent years.

Scheme pensions

The way in which DB pension schemes provide retirement income is by way of a scheme pension. This will be payable for the life of the member, and will be taxed as income using the same method as an employee: pay-as-you-earn. 

It means that the member should not have to pay any additional tax if this is their only income. It can also mean that other tax due can be paid through the scheme – such as any tax due on the state pension – by adjusting the tax code accordingly.

Scheme rules and legislation will determine how the pension increases each year, and which benefits will continue should the original member die. In most cases, the scheme will only pay 50 per cent of the original benefit to the surviving spouse on the member’s death. This will usually be for the rest of their life. The income the surviving spouse receives will be taxed as income on the recipient under PAYE rules.

DC pension schemes

Defined contribution pension schemes, also known as money purchase pension schemes, can be either occupational or personal schemes. Pension freedoms apply in such cases, so most changes in recent years have occurred to these types of plans. 

These schemes are made up of contributions made by employers and/or individuals, plus any applicable tax relief, and they are then invested and the benefits payable are determined by the fund available at the time.

Standard annuity

An annuity is an insurance contract purchased by the member or the pension scheme to guarantee the member an income for life. 

There are also other options that can be added to give the annuity useful attributes, such as increases in payment, a guarantee that the annuity will be paid for a certain time even if the member dies, or an income for a nominated individual after the member’s death. All these options will come at a cost, so the value of each needs to be determined in respect of each individual.

Annuities were all treated the same until the introduction of the pension freedoms in 2015. A standard annuity will be a level or increasing annuity, although the rises could be determined by indices such as the consumer price index or the retail price index.

Flexible annuity

The main difference between a standard annuity and a flexible annuity is that the flexible version will have the scope to decrease. This is most likely to be because it is linked to investments. The fact that it can decrease will mean the purchase of a flexible annuity will trigger the money purchase annual allowance.

Flexi-access drawdown

Flexi-access drawdown gives the greatest flexibility of all the pension retirement options, although with that comes risk. FAD allows a member to choose any level of income they want from their pension fund. How long the fund lasts will depend on the amount of income taken, the investment growth on the amounts that remain, as well as charges.

The product will usually pay out 25 per cent of each amount crystallised, tax-free (the PCLS). This could either be the whole fund or just some of it. But if the client wants the PCLS from the amount they are crystallising, then that decision needs to be made at the outset. The rest of the crystallised funds can be paid out at any time subject to income tax, in the same way a salary would have been under PAYE rules.

On death the funds can be paid out to any nominated individuals, either by a lump sum or income under beneficiaries FAD. Alternatively it could be paid out to a trust if that is more appropriate. 

The taxation of these benefits is dependent on the individual’s age at the point of their death. The funds will be free from income tax prior to the age of 75, and at 75-plus the funds will be taxed as income on the beneficiary or subject to a 45 per cent tax charge if paid to a trust – with a tax credit when benefits are then paid out.

Taking income under FAD will limit an individual’s annual allowance to £4,000, making them subject to the MPAA.

Capped drawdown

Although not available to those taking benefits for the first time after April 5 2015, additional funds can still be added to capped drawdown if it is already being used by an individual. 

Capped drawdown does not come with the same flexibility as FAD because an individual can only draw up to a certain level of income. This is determined every three years based on the age of the individual, the size of the funds, a table provided by the Government Actuaries Department, and current 15-year gilt yields. If more than this maximum amount – usually referred to as ‘max gad’ – is drawn, then the fund will be deemed to enter FAD. One of the reasons individuals remain in capped drawdown is to avoid the MPAA.

It should be noted that the individual will have already triggered the MPAA if they have one plan in FAD and one plan in capped drawdown. If that is the case, they may wish to consider switching the remaining capped drawdown fund to FAD regardless. This may save charges in the long run.

UFPLS

The uncrystallised funds pension lump sum was a new introduction in 2015 with the pension freedoms. It gives greater options to those in schemes that did not offer drawdown. However, it has not had the kind of take-up that some may have anticipated.

As mentioned, UFPLS provides 25 per cent of the lump sum tax-free and 75 per cent of the lump sum taxed as income under PAYE. It is probably the more complex administration, and dealing with the taxation, that has put off many pension schemes from offering this option. 

UFPLS is more popular in personal pensions that already offered drawdown before the freedoms. As with FAD, the fund will only last so long and this will be dependent on the same issues described earlier.

The benefit of UFPLS is that it is paid as a lump sum and the remainder of the fund in the pension will still be uncrystallised and available at a later date. This can be achieved through phasing FAD, but the paperwork may be simpler using an UFPLS.

Any payment of UFPLS will again make the member subject to the MPAA, limiting their annual allowance to £4,000 for money purchase pension schemes.

In some cases, the options at retirement will be limited because of the type of scheme or the plan’s rules. However, it is usually possible to transfer to another pension scheme if appropriate. Transfers from one type of pension plan to another can be complex, and advice should be sought to ensure that valuable benefits are not being given up for the perceived need of flexibility.

Retirement income is something that is designed to last for the rest of an individual’s life. Ensuring the right decisions are made at the right time can make all the difference and help ensure a long and happy retirement.

Claire Trott is head of pensions strategy at St James’s Place Group