Informed Choice

The 6th of April 2010 will, for many, mark a key date in their retirement planning.

Anyone who will be 50 before the beginning of the next tax year will have to make the decision whether it is appropriate to take their retirement benefits in whole, in part or to wait for up to a further five years.

Changes to the minimum pension age will mean the loss of access to pension benefits until age 55 with people at or approaching age 50 the most affected.

This article outlines the advantages of taking retirement benefits now plus warnings about doing so.

Advantages

1. Access to a Tax Free Lump Sum

Under current rules benefits from a pension scheme include a tax free lump sum equivalent to 25% of the fund value at retirement. This can be of great benefit where a capital expenditure is required, for example for home improvements, or to buy that dream car or, perhaps more prudently, to reduce a debt such as a mortgage.

2. Flexible Income

Contrary to popular belief an annuity is not the only income available from a pension. Unsecured Pensions (USP and also known as Income Drawdown) provides pension income that is more flexible.

It is possible to receive an income between nil and 120% of a rate set by the Government Actuary’s Department (the GAD rate). This rate is correlated to the yield available on Government Gilts and the individual’s gender and age.

This option is beneficial to those who require a capital sum but don’t want to receive any taxable income, those who want to start receiving a supplementary income and also to those who want the higher income than available via an annuity.

3. Continued Investment Growth

Unlike annuity purchase USP provides the opportunity to benefit from further fund growth because the pension fund stays invested. This can provide a higher level of annuity income when it is finally purchased.

4. Keep Contributing

Some USP contracts allow for pension contributions to continue despite having taken the tax free lump sum and income. This allows individuals to make use of the lump sum but to continue to build up their pension fund from which to take the guaranteed annuity income.

Contributions will continue to attract tax relief at 20% for basic rate tax payers with a further 20% reclaimable for higher rate tax payers.

Those earning £130,000 gross per annum or more should take note of the changes to tax relief announced in the 2009 Budget and Pre Budget Report.

Warnings

1. Worse Death Benefits

One significant disadvantaged of taking retirement benefits is worse benefits on death. Prior to taking benefits the pension fund can be passed to a nominated beneficiary as a lump sum free of any tax. Under USP this fund is taxed at 35%.

Worse still where an annuity has been purchased the pension fund can be lost entirely to the annuity provider. This can be mitigated against by adding options to the annuity that provide a dependants pension and guaranteed periods where the balance of payments continue to be paid for a maximum of ten years. However, when these options are added the starting income is reduced.

2. Loss of Tax Advantaged Growth

It is unwise to take the capital sum if it is not to be used. If the capital is only to be saved or invested it will have been transferred from an environment that grows free of tax (with the exception of a non reclaimable 10% tax credit on UK dividends) to one where both interest and capital gains are taxed.

3. Adding to Taxable Income

Unless an income is required any additional pension income (via any means) will simply increase the tax that is charged on total income at either 20% or 40% (and potentially 50% from April 2011).

4. Income erodes capital

If a USP contract is entered into and income is taken there is a risk that the income taken is greater than the investment growth received each year.

This will have the effect of eroding the capital value of the pension fund, which if occurs regularly or significantly in any given year, can be extremely detrimental to the final fund value used to purchased a guaranteed annuity income.

5. Loss of Purchasing Power

Annuity rates are determined by one’s life expectancy. The younger an individual the longer they will expect to live and therefore the greater income needed for life.

The result of this is a lower annuity rate offered by the annuity provider (they don’t want to pay more out in income than the original fund value they have received).

If a guaranteed income is relied upon for a long period of time (possibly for over forty years if bought at 50) the loss of purchasing power will be substantial over time as inflation reduces the value of £1.

This can be controlled by purchasing an annuity that increases each year either at a set percentage (3% or 5%) or by increasing in inflation (as measured by RPI). The disadvantage of this is that the initial annuity income provided is considerably less.

In fact, it can be in excess of ten years before an increasing income is equal to that of a level income.

This tax year therefore marks a key date for many and taking retirement benefits in any form can be extremely useful. However, care must be taken before irrevocable decisions are made.