Pension Drawdown - everything you need to know

Drawdown allows most pension holders to take a tax-free lump sum and reinvest the remainder to provide an income. Specific approaches include capped drawdown, flexi-access drawdown and optional, short-term annuities. The most appropriate method will depend on whether your client’s scheme was in place before 6 April 2015, and their particular aims and objectives.

What is drawdown?

Before drawdown was introduced in 1995, a pension holder (not being offered a scheme pension) had no choice but to buy an annuity at the point of taking benefits. Drawdown introduced an alternative to annuities, in that a client could take their tax-free lump sum (Pension Commencement Lump Sum, PCLS) and designate the balance of the pension funds to a drawdown contract. They could then draw an income from the drawdown contract, as long as they stayed within HMRC rules. Those rules have been subject to various amendments over the years and we will only cover the relevant versions in this article.

In the early days of drawdown contracts it was still a requirement to secure a pension by purchasing an annuity by age 75. However, this limitation was removed following principle objections to the requirement to purchase a lifetime annuity by the Plymouth Brethren and others.

From April 2011 until the introduction of the Taxation of Pensions Act 2014 on the 6 April 2015, there were two types of drawdown contracts – capped drawdown and flexible drawdown.

While capped drawdown remains for pension holders who elected this option before 6 April 2015, all flexible drawdown plans have been replaced by flexi-access drawdown. The funds of pension holders, who selected flexible drawdown prior to 6 April 2015, automatically became flexi-access on that date. The introduction of flexi-access drawdown also saw the introduction of ‘Uncrystallised funds pension lump sum’ (UFPLS)

For capped and flexi-access drawdown, the income can be provided direct from the fund, or from a short-term annuity.

Capped drawdown

Post 6 April 2015 capped drawdown is no longer available for new arrangements.

If on 5 April 2015 a capped drawdown fund was already in place, this arrangement can be retained. After April 2015, new funds designated under that arrangement present two options:

• before the new funds are designated, the existing capped drawdown arrangement can be converted into a flexi-access drawdown fund and the additional designation applied to flexi-access, or
  
  
• if the scheme allows, new funds can be designated to the existing capped arrangement and income can be drawn under this arrangement as per capped drawdown rules(however this may not be possible with some providers’ arrangements in which case they would require a new flexi-access drawdown arrangement to be set up for any future designations).

How capped drawdown works

The basics of a capped drawdown contract are relatively simple. At the point of crystallisation, the client can usually take a PCLS, tax-free, from the pension fund. But rather than buying an income using an annuity with the remaining funds, the funds continue to be invested within a crystallised pension. Any required income (within certain limits) can be withdrawn directly from the fund, or indirectly by purchasing a short-term annuity.

It is possible to continue pension contributions while in capped drawdown (although not into a drawdown plan which can only hold crystallised funds). Staying within the capped limits for income will not trigger the MPAA. More information on MPAA and all the trigger events can be found in the Money Purchase Annual Allowance article.

Assuming the MPAA is not triggered, contributions will still be subject to the standard (or tapered) annual allowance and it should be noted that pensions income doesn’t count as relevant UK income for the purposes of pensions tax relief.

If the maximum capped drawdown amount is exceeded, the capped drawdown fund will automatically be converted to a flexi-access drawdown fund and as such future defined contribution (DC) pension contributions will be liable to the Money Purchase Annual Allowance.

Death benefits in respect of capped drawdown are covered in our article on death benefits for defined contribution.

Income limits

There’s no minimum income from capped drawdown. However, there is a maximum income limit. The scheme administrator is required to calculate the amount of maximum annual income a member may take. This figure will be reviewed every three years, or annually if the member is over the age of 75 (this is known as the 'reference period').

Any payments over the maximum income limit would result in the capped drawdown arrangement being converted to a flexi-access account and withdrawals taxed accordingly

Finance Act 2004 Para 10 Sch 28 and s208

Maximum income / GAD limit

The current maximum income for capped drawdown, with effect from 27 March 2014, is 150% of the basis amount provided by Government Actuarial Department (GAD). Please see below for details of “GAD”.

Finance Act 2004 Section 165 Pension Rule 5

Amending the reference period

The member may ask for the reference period to be amended. It can only be reduced and not extended beyond the three-year period, and this can only take place at the end of the current pension year. For example if the reference period is due to run from 1 March 2018 to 28 February 2021, then a new reference period can only be started on 1 March 2019 or 1 March 2020. Any change to the reference period requires the consent of the scheme administrator.

The scheme administrator may not change the reference period without a request from the member.

Finance Act 2004 Sch 28 Para 10B

Recalculation of drawdown

There are certain events which trigger a recalculation of the drawdown payable. However, this doesn’t affect the reference period / review date. If the member is under age 75 there will be a recalculation if:

• part of the funds have been designated and then extra funds are designated into the same arrangement, or
  
  
• The member has requested an earlier review date and the scheme administrator has agreed to this.
  
  
• there is a pension sharing order or
  
  
• part of the drawdown funds are used to purchase a lifetime annuity or scheme pension.

Any changes to the maximum drawdown payable will be made from the start of the next pension year unless extra funds have been designated. If the extra designation produces a higher maximum drawdown pension, the higher amount will apply immediately. However, if it produces a lower maximum, the lower amount will only apply from the start of the next pension year.

If the drawdown pension fund is reduced because of a pension sharing order following the member’s divorce, this will trigger a recalculation of the maximum drawdown pension if the member is under age 75. The new maximum drawdown pension will take effect from the start of the next pension year. The maximum drawdown pension for the current pension year remains unchanged. The scheme administrator must calculate the new maximum drawdown pension as at the date the pension sharing order is put into effect – they can’t choose another date.

If the member is under age 75 and uses part, or all, of the drawdown pension fund to buy a lifetime annuity, there is a recalculation of the maximum drawdown pension.

The new maximum drawdown pension will take effect from the start of the next pension year, and the scheme administrator must calculate the new maximum drawdown pension as at the date of the lifetime annuity purchase. They can’t use another date.

If the member is 75 then yearly recalculations take place and no other recalculations take place unless extra funds are designated. After a recalculation or review, it’s possible the maximum drawdown pension is less than the current maximum. This could be due to a variety of factors such as low gilt yields and sustained bear market investment conditions. The Government Actuarial Department have said they will review the upper GAD rates as the drawdown population age.

Finance Act 2004 Sch 28 Para 10

GAD income limits

The maximum GAD limit is worked out by:

• calculating the age of the member in complete years at the date drawdown becomes effective
  
  
• obtaining the gross redemption yield on UK gilts (combined - 15 years) from FTSE UK Gilt indices for the fifteenth day of calendar month preceding the reference date (or last working day prior) (5yrs for under 23s eg dependant’s drawdown)
  
  
• the gilt yield is then rounded down to the nearest 0.25% unless it is an exact multiple
  
  
• the age from step 1 and the yield from step 3 is then used to look up the maximum drawdown rate in the appropriate table
  
  
• this is then multiplied by 150% to work out the maximum income that can be taken.

Drawdown transfers

Transfers may take place between capped drawdown funds. However, the transfer must be to a new arrangement and benefits must be provided on like-for-like basis eg short-term annuity to short-term annuity or income withdrawal to income withdrawal. If these requirements are not fulfilled then this will be classified as an unauthorised payment.

Transfers of capped drawdown funds need to be segregated from uncrystallised funds. Pensions can’t be transferred as partially crystallised arrangements.

On transfer, uncrystallised funds could be designated to an existing capped arrangement, or a flexi-access drawdown plan, used to buy an annuity, remain unvested, or used to pay UFPLS etc.

If a member transfers their capped drawdown fund then the same GAD limit, income amount and review periods follow the member. Capped drawdown arrangements can’t be combined with other capped arrangements, as the funds must be kept separate. This also applies to flexi-access drawdown, although no cap is in effect. Historically, one reason for this was to manage the information required to complete a future LTA test. Although the LTA no longer applies drawdown arrangements still need to kept separate on transfer. 

We also need to be mindful of the MPAA rules when considering the above options.

Dependant’s capped drawdown

Dependant's capped drawdown that began on or before 5 April 2015 may continue, providing there have been no events since that date resulting in its conversion to flexi-access drawdown. But no new dependant’s capped drawdown funds may be set up from 6 April 2015 onwards. You’ll find full details on the death benefits available from capped drawdown in our Death benefits from defined contribution schemes article.

Flexi-access drawdown

Flexi-access drawdown pension replaced flexible drawdown on 6 April 2015.

Using flexi-access drawdown, a pension holder can crystallise their pension fund, usually taking up to 25% of it as a Pension Commencement Lump Sum (PCLS) while the balance of the money continues to be invested (please note these funds are now crystallised funds).

A pension holder can then choose to draw as much or as little of the crystallised fund as they desire (no GAD limits). Withdrawals can be taken as a regular income stream, or one or more lump sums. These withdrawals can be provided directly from the pension fund or, if income is required, by the purchase of a short-term annuity (if the provider facilitates short-term annuities). Income tax will be chargeable on any withdrawals, at the pension holder’s marginal rate in the year of withdrawal (although it’s important to note that emergency tax may be applied to lump sums or the initial payments of income).

Receiving withdrawal payments from a flexi-access drawdown account (including receiving payments from a short-term annuity provided from a flexi-access drawdown fund), is a trigger event for the MPAA. As such, any ongoing DC pension contributions will be tested against the MPAA. It is important to note that previously flexible drawdown members had a “nil” annual allowance, so this is a softening of restrictions previously imposed on them.

However, it’s still possible to use ‘scheme pays’ to pay the MPAA excess charge, but the standard rules apply;

• the pension savings must exceed the standard AA in a particular scheme and
  
  
• the annual allowance charge (based on pension inputs to that scheme in excess of the standard annual allowance) is greater than £2,000.

In practice this means the member can’t force a scheme to pay an excess charge from funds where it related solely to an MPAA excess, but the scheme may offer to pay any charge on a voluntary basis. This will still lead to a reduction of the members pension fund.

Finance Act 2004 Sch 28 Para 8A

Finance Act 2004 Chapter 5 s227

Critical yield

If a member is considering using drawdown (capped if available, or flexi-access), then the financial adviser may consider ‘critical yield’ to be able to explain to the client whether drawdown is suitable.

The critical yield is the investment growth rate required in income drawdown to provide and maintain an income equal to that available under an annuity. This is referred to as critical yield A.

If a specific amount of income is being taken, then critical yield B is the investment growth rate required to provide that specified amount of income both in drawdown and on subsequent annuity purchase.

It’s reasonable to consider the critical yield along with all the other factors, such as gilt yields and annuity rates, as together these have implications for investment selection and whether drawdown is a suitable vehicle for the client. However, there are limitations to the critical yield, as achieving the critical yield provides no guarantee that the comparable income will be maintained. As such, critical yields should only be used as part of an overall assessment of suitability of drawdown.

Short-term annuities

Not all providers offer short-term annuities, but they can be used in combination with both flexi-access and capped drawdown, so it makes sense to cover them here.

Instead of drawing an income directly from the drawdown funds, drawdown funds can be used to purchase a short-term annuity to provide the required level of income.

Short-term annuities can be purchased from an insurance company. The term can’t exceed a maximum of five years, and pays a set amount over the set period. However, once a short-term annuity has been purchased the income amount can’t normally be changed (as would be possible with drawdown direct from a capped or flexi-access arrangement).

Short-term annuities can be used to provide income from capped or flexi-access drawdown. However, if arranged in connection with a capped drawdown case, the total amount of income payable from short-term annuities and drawdown mustn’t exceed the maximum income defined by GAD.

If capped drawdown is being used, a review must take place every three years, or annually from age 75. A short-term annuity may last for a maximum five years, so there can be an issue if the maximum drawdown reduces in the middle of the term of the short-term annuity. Any excess income would be an unauthorised payment unless retained within the fund.

Payments will only continue after the member's death if a guaranteed period was selected at outset.

Short-term annuities aren’t the same as fixed-term annuities

To clarify, only a fixed-term annuity is available using uncrystallised funds.

A fixed-term annuity may use all or part of either uncrystallised or crystallised pension funds to buy a retirement income for a set number of years. Where a provider offers it, a fixed term annuity can be set up on its own or as a Trustee Investment Plan within a pension scheme.

A fixed-term annuity provides a regular retirement income for a number of years – often five or 10 – with, or without, an agreed 'maturity amount' at the end of the specified period. Where there is a maturity amount, you can use this to invest in another retirement income product, such as another fixed-term annuity or a lifetime annuity, or you can take money out of your pension.

As covered, a short-term annuity is only an option where the client already has a drawdown pension fund (either capped or flexi-access) and it's purchased using some or all of these crystallised funds.