Flexible pension drawdown can be a key part of effective 'tax planning, says Scott Gallacher

31 Oct 2012News

In the last decade, a mixture of hope and frustration greeted the government’s radical overhaul of pension reform in 2006. Not only this, but a sense of irony too – since the project was entitled ‘pension simplification’.

Many of the changes introduced were sensible and long overdue, but ‘simple’ they certainly were not. And it wasn’t left there: governments of both colours (perhaps emboldened by the root and branch changes of 2006) have since introduced several further layers of changes, many of them very complex, and each with its own set of transitional arrangements.

Route master

However, if simplification has eluded us, we have at least seen some additional flexibility. An example of this was introduced just last year: flexible pension drawdown has genuinely enhanced the financial planning of several of our clients.

Flexible pension drawdown comes in at the point where, having built up a pension fund, a client wants to start taking the benefits. It might be helpful to set it in the context of its alternatives: the closely related ‘capped drawdown’, and the ‘traditional’ route of taking an annuity.

The usual way to take one’s benefits (and still appropriate for the majority of people), is to take a quarter as a tax-free lump sum (to save or squander according to taste), and to exchange the three quarters of the pot for a guaranteed, irrevocable life-long annuity. Until the mid-1990s, this was really the only way to access personal pension benefits.

At that point, the option that is now called ‘capped drawdown’ became available (originally termed ‘income drawdown’, and more recently ‘unsecured pension’). This allowed, for the first time, a pensioner to draw sums of money directly from their fund instead of taking an annuity – and this could be done all the way up to age 75 (an age limit since scrapped).

This revolutionary new flexibility had (and still has) two principal attractions: the ability to defer committing one’s capital to poor annuity rates and also the hope that by keeping the pension funds in place for longer, extra investment growth could be achieved.

Most importantly, however, capped drawdown allows withdrawals only up to a certain limit (broadly speaking, a comparable amount to that available under an annuity), and the limits are reviewed every three years. These withdrawal limits are designed to stop the fund being drained dry.

Considered plan

The big difference with the new flexible drawdown is that there are no limits on the annual withdrawal amounts. A client can even take 100 per cent of the fund in one go. However, for obvious reasons, eligibility was made subject to certain conditions:

the client must already be in reciept of pensions that will guarantee at least £20,000 gross pension in that tax year and future years;
the client must not make any pension contributions in the year they start flexible drawdown. Also, any future premiums would suffer a tax charge designed to wipe out the tax benefits of future contributions;
it is only possible to elect for flexible drawdown once and the election covers only one scheme (other pension arrangements held are not affected).

It is also worth noting that money taken via flexible drawdown (even if in the form of a lump sum), is still treated as ‘income’, so it is subject to income tax like any other pension income.

Flexible drawdown is not right for everybody and there are certainly drawbacks. However, where it is part of a considered plan, it can be a powerful tool. A recent case will help to illustrate one of several possible strategies (see box).

Many clients, quite understandably, are extremely eager to avoid committing their money to historically poor-value annuities, not to mention the loss of control over the capital and the fact that the money is simply lost on death. (The corollary fact that, if they live long, they will receive far more than they ever paid in, rarely balances the scales in clients’ eyes!)

But that doesn’t necessarily mean using flexible drawdown to access one’s capital is always a good idea, especially where a client is likely to husband it wisely to support their retirement. Indeed, there is some concern that these new rules will serve to undermine the hoped-for pension savings culture that we would all like to see take better hold. There might, after all, be something to be said for the enforced prudence of an annuity that genuinely provides a life-long income.

Of course, these caveats highlight the point that in financial planning (and especially with sophisticated planning tools such as flexible drawdown), the most important step is the first: to sit down with a qualified professional and look at things from every angle. Flexible drawdown certainly isn’t for everybody – but Bob is absolutely delighted.

Flexible drawdown: an example

?A long-standing client, Bob, is a business owner now thinking ahead about retirement. He is taking about £100,000 a year, a mixture of salary and dividend. He doesn’t actually need all of this income day-to-day, but his longer-term financial plans mean that it’s important to extract this money from the business before he retires and passes on the business.

He can see that for every pound the company earns, a combination of corporation tax and dividend income means an overall tax burden of 40 per cent before it finally arrives in his wallet. Can we do anything to reduce this burden? Yes.

Bob already has pensions in payment of about £25,000 and he doesn’t want to commit any more money to retirement income. Nevertheless, he sets up a new pension plan that has the option for flexible drawdown. He reduces his drawings by £30,000, and instead the company pays £30,000 year into the new pension, for the next five years.

But, of course, this isn’t actually about pension planning in the traditional sense at all; it’s about tax-efficient capital extraction.

Now fast forward five years, when it is time to take the money (now standing at £150,000 ignoring investment growth and charges).

First of all, as with almost all pensions, he can take a quarter as a tax-free lump sum. With the remaining £112,500 he could use flexible drawdown to take it all in one go, but if he did that, much of it would bear higher-rate income tax.

However, at this point Bob’s salary will have stopped and he can now choose to withdraw a series of lump sums to use up his remaining basic-rate tax band (about £17,000 a year). This would take about six years, but if he wanted it sooner, he could encroach into the higher rate tax band at the expense of some additional tax.

Assuming Bob keeps the yearly withdrawals within the basic rate tax band, the overall tax burden on the £150,000 is only £22,500 – just 15 per cent. This is an enormous improvement on the £60,000 (40 per cent) that was the case before.

It’s worth noting that if Bob were to die before drawing benefits (and before age 75) then his wife or family would receive the entire pension fund without any income tax or inheritance tax deduction: a further valuable benefit.

Scott Gallacher is a director at independent financial advisers Rowley Turton. He can be contacted on scott@rowleyturton.com. For more information, see ?www.rowleyturton.com

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