We’ve looked at DB pensions, so let’s now turn to Defined Contribution or DC pensions. These are the pensions that most of us have these days, where rather than a promise of a future income based on salary and service, you simply build up a fund of money which you want to be as big as possible by the time you retire. Both you and your employer will pay in (assuming you have an employer of course) and there are tax benefits to paying into a pension.
When you get to the point of retirement, you have a bunch of options for what’s called ‘crystallising’ your pension funds – i.e. taking funds out. The first is whether or not to take a 25% tax-free lump sum out of your pension and into your bank account. You only get this option once for every bit of money you crystallise. Importantly you don’t have to crystallise all your pension fund(s) at once, you can do it in tranches.
Whether or not you take a tax-free lump sum, your left with a remaining fund and you then have to decide what to do with that. One option is to hand over the fund in return for a guaranteed income for life, called an annuity.
If you do this, you have a bunch of options for the income – you can have it indexed (that is, it increases every year for life) you can have a survivor’s annuity paid to your spouse or civil partner if you die first, you can have it paid for a minimum of (say) ten years, even if you die within that period and you can even decide on the frequency of payments such as monthly or quarterly or annually.
Annuities have fallen significantly out of favour in the past couple of decades for a couple of key reasons. The first reason is that annuity rates, that is the amount of income you get for each £1,000 of fund you hand over, has gone down significantly compared with when I first entered the advice world in 1998.
The annuity companies come up with their rates based on your health and age and life expectancy. As life expectancy has risen, the annuity companies are going to be paying out for longer, and so they pay out less each year to compensate.
The biggest factor though is that an income for life is a massive uncertainty. After all, none of us know how long ‘for life’ actually is. This meant there was a large amount of cross-subsidy going on, inevitably. If you lived to 100, the annuity company would likely be out of pocket, but for every centenarian, there’s someone who tragically dies early after only receiving a few annuity payments. Those who die early subsidise those who live too long, from the point of view of the insurance company.
The actuaries working for the annuity companies can work this out and come up with an average annuity rate that they pay you. But if you hand over a lifetime’s worth of pension savings and only get a few grand in annuity payments before dying too early, that’s sickening to say the least.
And that’s why income drawdown – more properly called unsecured pension – was invented. This is the main alternative to annuity purchase and all that happens is that your money stays invested in a pension fund, just as it has been all the time you were building it up, and you draw what you need from that as you need it.
Think of it as a bucket with a tap on the side. The level of water is the value of your pension fund and you open the tap to draw off income as you need it. And if you think that analogy through, if you keep the tap open too fast for too long, the water level is going to go down to nothing, that is, you’ll run out of pension fund money altogether.
In the move towards drawdown, the pension companies have shifted all the risk onto you, the individual. Now, rather than having to work out longevity figures and cross-subsidy and come to an annuity rate that is market-friendly and also makes them a profit, it’s now up to you to make your money last as long as possible.
If you’re in a DB scheme, the scheme just has to have enough money in to pay you for the rest of your life, no matter how long that is. You have to make it last as long as possible.
Actually, if you think of two buckets, one of which is your pension fund before you crystallise and one which is after, you can shift money from uncrystallised to crystallised at whatever point you want and in whatever proportion you want.
So you could do all of your pension pot in one go, or just as much as you need when you need to take it, or whatever. It’s very flexible. When you move money from uncrystallised to crystallised, that is the point at which you get the option to take a quarter of it out as tax-free cash.
Just to complicate things further, you can avoid the crystallised bucket altogether and do something called an UFPLS – Uncrystallised Funds Pension Lump Sum. Let’s say you want to take £10k out of your pension and into your bank account. You could do an UFPLS for £10k, of which £2.5k would be tax-free and the other £7.5k would be taxable. This avoids having to set up a drawdown account, as such, that’s all.
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