INCOME DRAWDOWN has built a significant share of the market for ‘retirement’ funds. According to Association of British Insurers figures, from a standing start in the mid-1990s, drawdown currently accounts for over 17 per cent of new funds earmarked to provide retirement income and we believe this trend is set to continue.
One underused feature of income drawdown is its ability to combine withdrawals of both tax-free cash and taxable income, otherwise known as ‘phased drawdown’. This concept has been further developed to allow automatic monthly vesting of benefits combining tax-free cash and income. This is known as ‘drip-feed drawdown’.
At its heart, drip-feed drawdown is a very simple concept – rather than drawing all of the tax-free cash up front, clients draw it gradually and treat the tax-free cash as part of their income.
This could be particularly useful for people who want to control the pace of their journey into full retirement. Typically, customers running their own businesses were the most likely to gradually phase into retirement. Nowadays, many more people are going back to work after their official retirement date and they too could benefit from this approach.
The European Directive preventing age discrimination should also have a major impact in this area. From the end of 2006, the UK is obliged to implement this Directive, by enacting new legislation to prevent employers from compulsorily retiring workers at a given age. This should put the decision on when to stop work firmly in the employee’s court.
Drip-feed drawdown has two main advantages. First, it can minimise the amount of income tax payable, but it can also maximise tax-free lump sum death benefits.
For someone gradually moving into retirement, minimising income tax is very important. What is the point of going back to work, when the combined total of your earnings and pension income pushes you back into the higher rate tax bracket?
Take for example a 60-year-old male client, who is a UK taxpayer and has earnings £500 below the threshold for higher rate tax. Suppose he needs another £3,000 income after tax to meet his needs.
If he takes this purely in the form of taxable income, he would have to draw a gross annual amount of £4,850, £500 pounds of which would be taxable at the basic rate (£500 – 22% = £390) and the remaining £4,350 at higher rate (£4,350 – 40% = £2,610; £2,610 + £390 = £3,000).
Alternatively, he could draw a combination of tax-free cash and taxable income. Vesting just £11,280 of his fund would give him tax-free cash of £2,820 and a taxable income of just £231 a year from the remaining £9,000 (at the current prescribed minimum and based on current gilt yields of 4.75%). After basic rate tax, the net income would be £180, which, together with the tax-free cash, would deliver the desired income level of £3,000 for that year.
In the first alternative, drawing purely taxable income, our customer has paid tax amounting to £1,850 in this year alone. In the second alternative, by using tax-free cash as income, our customer has paid extra tax of only £51 to enjoy another £3,000 of net income.
This concept is explained in the chart. Using a combination of earned income, taxable pension income and tax-free cash, this shows how full retirement can be gradually introduced. The ‘existing pension income’ is the taxable drawdown income from previous withdrawals. The ‘new pension income’ is the taxable drawdown income from the current year’s withdrawal.
Another major benefit of drip-feed drawdown is the advantageous tax treatment applied to death benefits. Where funds resulting from voluntary savings remain un-drawn, they can be paid without deduction of tax on death. However, any drawn fund paid as a lump sum to a widow or dependant on death is subject to 35% tax. Drip-feed drawdown minimises the amount of funds drawn and hence the potential tax charge on death.
Innovative features such as drip-feed drawdown are likely to provide another shot in the arm for the drawdown market. This should further establish drawdown as an increasingly popular method of providing retirement income.
As can be seen, much is changing in the pension-planning world and, in the run up to UK pensions’ A day (June 6, 2006), anyone who has contributed to a UK-based pension scheme would be wise to review their arrangements to take full advantage of the new pension laws and flexibility.Contributed by JOHN WESTWOODManaging Director,Blacktower Financial Management Limited