Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
Time to review pension drawdown arrangements
The amount of pension income you can receive from a capped drawdown product has been curtailed, further increasing the attractiveness of flexi-access drawdown. But there are lots of things to consider before making the move to this type of product.
What is capped drawdown?
Capped drawdown is a type of income drawdown product that was available before 6 April 2015. Like the newer flexi-access drawdown, it enables you to take a tax-free cash sum of up to 25%. The remainder is invested into funds designed to pay you an income.
Unlike flexi-access drawdown, the amount of income you can receive is capped. The cap is 150% of the income a healthy person of the same age could get from a lifetime annuity. This figure is worked out using Government Actuary Department (GAD) rates, which are based on an investor’s age and the yield on 15-year Government gilts from the 15th day of the previous month.
Why has the income limit fallen?
At the start of this year HMRC published new GAD tables to reflect the fall in gilt yields. It removed the previous 2% floor and introduced a new lower limit of 0%.
On 1 July, these new GAD rate tables took effect. The gilt yield for July was confirmed as 1.56%, which was rounded down to 1.5% for the purposes of calculating capped drawdown income limits.
According to Suffolk Life, this means a £3 or £4 drop in the rate per £1,000. A 60-year-old investor with a £200,000 pension will have a new income limit of £12,900 – a £900 drop from the £13,800 limit which would have applied if the 2% minimum rate was used.
What are the advantages of capped drawdown?
Although your income limits will have dropped, there are still several advantages to using capped drawdown.
One of the main benefits is you can continue to contribute up to £40,000 per year into your pension. This is because your Money Purchase Annual Allowance (MPAA) won’t be triggered.
If you switch to flexi-access drawdown, the amount you can save into your pension once you start drawing an income is much lower. You will trigger the MPAA, which was slashed from £10,000 to just £4,000 from April 2017.
Ian Browne, pensions expert at Old Mutual Wealth, says this makes capped drawdown a good option for people who have an unpredictable or irregular working life and income, who may be caught out by the MPAA.
This could include people who are taking a staged retirement; or those who have been made redundant, start drawing an income and then get a new job.
Browne says the cap set by the GAD rate can also act as a guide for investors to help them manage their drawdown funds over the long term.
What are the pros and cons of flexi-access drawdown?
For some people it may be better to switch to flexi-access drawdown. Danielle Byrne, technical resources consultant at AJ Bell, says the main benefit is the ability to take unlimited withdrawals from your pension, thus giving you greater flexibility and freedom.
‘It may seem like a better fit for modern retirement,’ she says.
As well as triggering the MPAA, a downside of flexi-access drawdown is that without a cap you don’t have any sort of guide over what a sustainable withdrawal could be.
‘Although there are no uppermost limits, an individual should assess the sustainable level of income from the fund in order to make informed decisions about their level of drawings,’ advises Martin Tilley, director of technical services at Dentons Pension Management.
There’s also a risk that if you withdraw too much money you’ll be pushed into a higher income tax bracket and be hit with a hefty tax bill.
It’s important to realise that once you switch to flexi-access drawdown you can’t reverse it, so you need to be sure it’s the right decision for you.
Are there any other options?
There are a few other options if you’re in capped drawdown and need to make up your pension income shortfall.
Browne says you could rely on your other assets, for example your ISAs. You can draw as much money as you like from an ISA and the withdrawal won’t be subject to income tax.
It’s also possible that you have other pension benefits you could rely on, such as the state pension or other personal and occupational pensions.
Another option is to take an uncrystallised funds pension lump sum (UFPLS). Under UFPLS rules, you can take lump sums as and when you want without going into drawdown. Usually 25% of each withdrawal is tax-free and the rest is taxable. Your remaining pension can stay invested.
A downside is that as soon as your first UFPLS is taken, the MPAA will be triggered. In addition, taking high withdrawals could push you into a higher income tax bracket.